Question

Explain the relationship between the structural budget deficit and contractionary changes in fiscal policy with a diagram [You only need to draw the diagram]. [7 Marks]

Answer 1

There has been a structural budget deficit that has been going on in the US as the country spends more than it earns.

Contractionary changes in the fiscal policy involve either decrease in government spending or increase in taxes or both. It showcases the real GDP of the country by keeping the values of the base year.

The relationship between the structural budget deficit and the contraction changes in discal policy is that with the decrease in the government spendings and the increase in taxes leads to decrease in the demand for the products, it ultimately reduces the production by the firms. As the domestic production of goods falls, the country has to meet the demand by importing from foreign nations leading to increasing the foreign exchange or the spendings by the government. This way the economy leads to the budget deficit.

In the figure, LRAS (Long-Run Aggregate Supply) is vertical to the price level because in the long run the supply of goods is not affected by the price level of the product. But, in the short run, the SRAS (Short-Run Aggregate Supply) is positively inclined with the price level of the products. Here, the Aggregate Demand of the products is given in the short run, this shows the above situation of decrease in government spendings by the firms which lead to production to go down, people will not be buying goods, therefore, the demand will also go down for the products. This will come to equilibrium when the government will be increasing the imports and government spendings on goods.