Question

Discuss the relationship between the actual budget surplus and the HEB after the negative demand shock (i.e., in SR), assuming they are equal before the shock occurs. In other words, explain why one is larger than the other after the shock. Your answer should consider both the case where the actual budget surplus is required to be zero and the case where there is no restriction on the actual budget surplus

HED = High-Employment Budget Surplus

Answer 1

Budget Surplus:

Budget Surplus (BS) is the excess of the Government’s revenue (taxes) over its total expenditure, which consists of purchase of goods and services and transfer payments. BS is a function of level of income, for a given, government expenditure, transfer payments and income tax.

When tax rate increases

This will lead to increase in the BS

Thus, increase in taxes with government expenditure constant will not lead to decrease in BS

BS will be unchanged.

Full-Employment Budget Surplus (Bs*):

Cyclically adjusted surplus (or deficit)/

high-employment surplus/

standardized budget surplus/

structural surplus.

It is the BS at full-employment level of income. The full-employment budget surplus (BS*) shows the budget-surplus (BS) at the full-employment level of income (Y*)

If budget surplus is used to measure the effects of Fiscal Policy, then the BS can change if there is a change in the Autonomous private spending.

According to Dornbusch and Fischer:

1. Full-employment level means an unemployment rate of about 5 to 5.5%. This rate will differ depending on the assumptions made about the economy at full employment.

2. High-employment surplus is not a perfect measure of fiscal policy because fiscal policy involves a number of variables like the tax rate, transfers and Government purchases

Notice that in recession years, like the early 1990s, 2001, or 2009, the standardized employment deficit is smaller than the actual deficit. During recessions, the automatic stabilizers tend to increase the budget deficit, so if the economy was instead at full employment, the deficit would be reduced. However, in the late 1990s the standardized employment budget surplus was lower than the actual budget surplus. The gap between the standardized budget deficit or surplus and the actual budget deficit or surplus shows the impact of the automatic stabilizers. More generally, the standardized budget figures allow you to see what the budget deficit would look like with the economy held constant—at its potential GDP level of output.

Automatic stabilizers occur quickly. Lower wages means that a lower amount of taxes is withheld from paychecks right away. Higher unemployment or poverty means that government spending in those areas rises as quickly as people apply for benefits. However, while the automatic stabilizers offset part of the shifts in aggregate demand, they do not offset all or even most of it. Historically, automatic stabilizers on the tax and spending side offset about 10% of any initial movement in the level of output. This offset may not seem enormous, but it is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if they reduce the impact of the worst bumps, even if they do not eliminate the bumps altogether.

Budget deficits and surpluses can help to stabilize the economy. If the economy enters a recession taxes will fall as income and employment fall. At the same time, government spending will increase as people are given unemployment compensation and other transfers such as welfare payments. Such automatic changes in revenue and expenditures work to increase the deficit. At the same time, they also work to mitigate the decrease in disposable income that households are experiencing. This maintains consumption at a higher level than would otherwise be the case.

If the economy is in an expansion and experiencing inflation, a budget surplus works to stabilize the economy. In this instance taxes increase in response to the increase in employment and income. At the same time, government expenditures fall as fewer individuals receive unemployment compensation and other transfer payments. These changes work to lower the level of consumption and hence the level of aggregate demand. Thus, the surplus works to stabilize the economy during inflationary periods.

In the case of inflation, we find that revenue rises automatically while expenditures fall. It is possible that such changes would create a surplus. In order to eliminate the surplus, government must lower revenue (by cutting taxes) and increase expenditures. Both actions would work to increase disposable income. This increase in disposable income will then work to increase consumption and hence aggregate demand. As aggregate demand rises, the price level will increase further thereby worsening inflation. Hence, if one is concerned with stabilizing the economy, an annually balanced federal budget would be undesirable.