A. The federal government ran a budget surplus in the late 1990 and in the year

Question

A. The federal government ran a budget surplus in the late 1990 and in the year 2000, but has since returned to running a budget deficit. 1. Explain why reducing the budget deficit can cause short-term pain in the form of lower employment, higher unemployment, and a recession. 2. Explain why expansionary monetary policy would help decrease the likelihood of a recession if it were adopted at the same time the budget deficit was being reduced. 3. Present an analysis that identifies any long term gains which could result from a reduction in the budget deficit. (Analyze the composition of output.)

Explanation / Answer

A.
1.
Budget deficit is reduced either by reducing the government spending and or increasing the tax. It reduces the aggregate demand and in response to this, aggregate supply comes down. It causes the firms to lay off the employees. It increases the unemployment that further reduces the aggregate demand. As a result, a chain of negative economic activities takes place and the economy moves into the recession.

2.
When budget deficit comes down, then government spending comes down, but it creates the negative impact of the crowding out effect of the government spending. At his time, the expansionary monetary policy causes the increase in money supply and made money available for loans to the firms and households at lower interest rates. As a result, firm increase the investment spending and consumers also take loans to compensate for the decrease in government spending. Hence, the recessionary impacts are nullified with balanced aggregate demand.

3.
The output is the sum of household consumptions, investment spending, government spending and net export. As a long term change, if government spending comes down and subsequent negative effect of the crowding out effect also comes down, then expansionary monetary policy cause the firms to take more funds and increase their investment. Household consumption also increases with attractive interest rates. Hence, the decrease in government spending is more than compensated by increase in investment and consumption component of output. Further, capacity building among the firm, also boosts the net export. All these developments are good for the economy in the long term.

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