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
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
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
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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