In Year 1, the cyclically adjusted budget showed a deficit of about $100 billion and the actual budget showed a deficit of $150 billion one year. In Year 2, the full employment budget showed a deficit of about $125 billion and the actual budget showed a deficit of $150 billion. Based on these data, what can be concluded about the direction of fiscal policy?
What will be an ideal response?
Fiscal policy was expansionary because the cyclically adjusted budget deficit increased from one year to the next. The actual deficit is composed of the full-employment portion and the cyclical portion. The full-employment portion of the actual budget deficit rose from $100 to $150 billion. The cyclical portion is determined by taking the actual deficit and subtracting the cyclical portion from it. The cyclical portion of the actual deficit fell from $50 billion to $25 billion. The actual budget deficit did not change, but it does not provide a good indication of the direction of fiscal policy. Only the cyclically adjusted budget tells the direction of fiscal policy.
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