THE BUDGET BALANCE
• Budget balance (savings by government) is defined by:
where : tax revenues
: government purchases of goods and services
: value of government transfers
• Recall that a positive budget balance is a budget surplus, and a negative budget balance is a budget deficit.
• Effects of fiscal policies:
o Expansionary fiscal policies (increased government purchases, higher government transfers, lower taxes) decrease the budget balance.
o Contractionary fiscal policies increase the budget balance. • Why it is misleading to measure fiscal policy using changes in budget balances: 1. Two different changes in fiscal policy that have equal-size effects on the budget balance may have unequal effects on the economy (example: government purchases have a larger effect on real GDP than equal-size changes in taxes and transfers). 2. Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy.
• Cyclically adjusted budget balance - an estimate of what the budget balance would be if real GDP were exactly equal to potential output
o Takes into account the extra tax revenue the government would collect and the transfers it would save if a recessionary gap were eliminated, or the revenue the government would lose and the extra transfers it would make if an inflationary gap were eliminated.
• Should the budget be balanced?
o Persistent budget deficits can cause problems for both the government and the economy.
o Yet, politicians are always tempted to run deficits as they can then cater to voters by cutting taxes without cutting spending or increasing spending without increasing taxes. o As a result, policy makers occasionally make attempts to force fiscal discipline by introducing legislation to balance the budget.
o Economists argue that the government should only balance its budget on average--that it should be allowed to run deficits in bad...
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