Define the cyclically adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP₃ (not GDP₂) in the economy depicted in Figure 13.3. If the economy is operating at GDP₂ instead of GDP₃, what is the status of its cyclically adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

The cyclically adjusted budget is the estimate of the budget when the economy operates at the full employment level. It is referred to as to cyclically adjusted budget because it eliminates the impact of cyclical changes in the economy and measures the budget status of what it should be in an ideal situation.

A cyclically adjusted budget compares the actual budget status with the full employment situation. It helps to understand how far the actual budget stands from the ideal position and what amount should be adjusted to reach the full employment level of the budget.

A cyclically adjusted budget differs from the actual budget because of the automatic stabilizers. The automatic stabilizers increase the budget deficit in times of recession and decrease the budget deficit during inflation. Therefore, as GDP fluctuates from the equilibrium level, the budget also deviates in the same direction.

The cyclically adjusted budget is the measure of the budget at the full employment level.

The full employment level of the real domestic output is GDP3. The tax revenue at GDP3 is greater than the government spending, which is constant. Thus, the cyclically adjusted budget is in surplus.

If Taxes > Government Spending; Contractionary Fiscal Policy.

If Taxes< Government Spending; Expansionary Fiscal Policy.

Since the cyclically adjusted budget is in surplus, the taxes are higher than government spending. Thus the current fiscal policy is contractionary.

The actual budget at GDP2is balanced, and the economy is practicing a contractionary fiscal policy. However, the cyclically adjusted budget is in surplus. The government must adopt an expansionary fiscal policy to reach full employment, increasing the GDP and reducing the budget surplus.

Therefore, the economy will be at full employment with a cyclically balanced budget.

To maintain a balanced budget, the government should either increase government spending, decrease taxes, or apply both. The changes in government spending and tax revenue should be such that the line government spending, G, and tax revenue, T, should intersect at full employment, GDP₃.

When tax revenue and government spending curve meet, the cyclical budget will be fully balanced.