1. a. The amount of taxes at natural real GDP equals .2(11,600) 2,320.

b. There is a natural employment deficit because taxes (2,320) are less than government

spending (2,610). The amount of the deficit equals 2,320 −2,610 −290. The natural

employment deficit as a percentage of natural real GDP equals −290/11,600 −.025

−2.5 percent.

c. For the natural employment deficit to equal one percent of natural real GDP, the natural

employment deficit must equal −.01(11,600) −116 billion.

d. For fiscal policymakers to achieve their goal, T −G −116, and since T 2,320 at natural real

GDP, given no change in the tax rate, 2,320 −G −116 or G 2,436. Therefore, to achieve

their goal, they must reduce government spending to 2,436 or equivalently, cut spending by

174 billion.

e. For fiscal policymakers to achieve their goal, T −G −116 and since G 2,610, given no

change in government spending, t(11,600) −2,610 −116, or t(11,600) 2,494. Therefore, the

tax rate, t, must equal 2,494/11,600 .215 for fiscal policymakers to achieve their goal, given no

change in government spending.

Chapter 5 The Government Budget, Foreign Borrowing, and the Twin Deficits 51

f. Fiscal policymakers must either raise the tax rate or cut government spending in order to

accomplish their goal of reducing the natural employment deficit to one percent of GDP. Either

action has a contractionary effect on real income. Therefore, monetary policymakers would have

to take action to lower the interest rate in order to offset the contractionary effect of fiscal

policy.

g. The fiscal-monetary policy mix described in Parts c through f reduces the interest rate. Since

private saving falls as the interest rate declines, national saving increases by an amount that is

less than the decline in the natural employment deficit.

2. a. The amount of taxes at actual real GDP equals 0.16(10,600) 1,696, whereas the amount of

taxes at natural real GDP equals 0.16(10,900) 1,744.

b. The amount of the natural employment deficit equals 1,744 −1,890 −146.

c. The amount of the actual deficit equals 1,696 −1,890 −194. Since actual real GDP is less than

natural real GDP, there is a cyclical deficit. Since the actual deficit is the sum of the cyclical and

natural employment deficits, the cyclical deficit equals the actual deficit minus the natural

employment deficit, which equals −194 −(−146) −48.

d. Taxes now equal 0.14 (10,900) 1,526 at natural real GDP.

e. The amount of the new natural employment deficit equals 1,526 −1,890 −364. The natural

employment and actual deficits are now equal because the economy is now operating at natural

real GDP. That is also why there is neither a cyclical deficit nor a cyclical surplus.

f. Since monetary, as opposed to fiscal policy, is used to increase output to natural real GDP, the

natural employment deficit is the same as it was in Part b. As in Part e, the natural employment

and actual deficits are now equal because the economy is now operating at natural real GDP.

The reason that the natural employment deficits are different between Parts e and f is that a

change in fiscal policy changes the amount of the natural employment deficit or surplus,

whereas a change in monetary policy does not.

g. Since the economy is a large open economy, the cut in the budget deficit results in a drop

of the domestic and foreign interest rates to 4.4 percent. The drop in the interest rate causes

investment demand to rise by 50 billion to 1,850 and private saving to fall by 30 billion to 2,080.

So national saving only rises by 170 billion from 1,760 to 1,930. The 80 billion dollar gap

between national saving and investment demand means that net exports increase by 120 billion

from −40 to 80. That results in foreign lending of 80 billion.

h. The difference between small and large open economies is that in the former, a cut in the

budget deficit has no impact on interest rates, foreign or domestic. Therefore, a change in the

government’s deficit affects only net exports and foreign borrowing or lending. In a large open

economy, a change in the government’s deficit has an impact on foreign and domestic interest

rates. Therefore, investment demand, private and national saving, net exports, and either foreign

borrowing or lending are all affected by a change in the government’s deficit.

b. There is a natural employment deficit because taxes (2,320) are less than government

spending (2,610). The amount of the deficit equals 2,320 −2,610 −290. The natural

employment deficit as a percentage of natural real GDP equals −290/11,600 −.025

−2.5 percent.

c. For the natural employment deficit to equal one percent of natural real GDP, the natural

employment deficit must equal −.01(11,600) −116 billion.

d. For fiscal policymakers to achieve their goal, T −G −116, and since T 2,320 at natural real

GDP, given no change in the tax rate, 2,320 −G −116 or G 2,436. Therefore, to achieve

their goal, they must reduce government spending to 2,436 or equivalently, cut spending by

174 billion.

e. For fiscal policymakers to achieve their goal, T −G −116 and since G 2,610, given no

change in government spending, t(11,600) −2,610 −116, or t(11,600) 2,494. Therefore, the

tax rate, t, must equal 2,494/11,600 .215 for fiscal policymakers to achieve their goal, given no

change in government spending.

Chapter 5 The Government Budget, Foreign Borrowing, and the Twin Deficits 51

f. Fiscal policymakers must either raise the tax rate or cut government spending in order to

accomplish their goal of reducing the natural employment deficit to one percent of GDP. Either

action has a contractionary effect on real income. Therefore, monetary policymakers would have

to take action to lower the interest rate in order to offset the contractionary effect of fiscal

policy.

g. The fiscal-monetary policy mix described in Parts c through f reduces the interest rate. Since

private saving falls as the interest rate declines, national saving increases by an amount that is

less than the decline in the natural employment deficit.

2. a. The amount of taxes at actual real GDP equals 0.16(10,600) 1,696, whereas the amount of

taxes at natural real GDP equals 0.16(10,900) 1,744.

b. The amount of the natural employment deficit equals 1,744 −1,890 −146.

c. The amount of the actual deficit equals 1,696 −1,890 −194. Since actual real GDP is less than

natural real GDP, there is a cyclical deficit. Since the actual deficit is the sum of the cyclical and

natural employment deficits, the cyclical deficit equals the actual deficit minus the natural

employment deficit, which equals −194 −(−146) −48.

d. Taxes now equal 0.14 (10,900) 1,526 at natural real GDP.

e. The amount of the new natural employment deficit equals 1,526 −1,890 −364. The natural

employment and actual deficits are now equal because the economy is now operating at natural

real GDP. That is also why there is neither a cyclical deficit nor a cyclical surplus.

f. Since monetary, as opposed to fiscal policy, is used to increase output to natural real GDP, the

natural employment deficit is the same as it was in Part b. As in Part e, the natural employment

and actual deficits are now equal because the economy is now operating at natural real GDP.

The reason that the natural employment deficits are different between Parts e and f is that a

change in fiscal policy changes the amount of the natural employment deficit or surplus,

whereas a change in monetary policy does not.

g. Since the economy is a large open economy, the cut in the budget deficit results in a drop

of the domestic and foreign interest rates to 4.4 percent. The drop in the interest rate causes

investment demand to rise by 50 billion to 1,850 and private saving to fall by 30 billion to 2,080.

So national saving only rises by 170 billion from 1,760 to 1,930. The 80 billion dollar gap

between national saving and investment demand means that net exports increase by 120 billion

from −40 to 80. That results in foreign lending of 80 billion.

h. The difference between small and large open economies is that in the former, a cut in the

budget deficit has no impact on interest rates, foreign or domestic. Therefore, a change in the

government’s deficit affects only net exports and foreign borrowing or lending. In a large open

economy, a change in the government’s deficit has an impact on foreign and domestic interest

rates. Therefore, investment demand, private and national saving, net exports, and either foreign

borrowing or lending are all affected by a change in the government’s deficit.

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