Cyclically Adjusted Deficit

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Definition of a Cyclically Adjusted Deficit:

A cyclically adjusted deficit is a budget deficit caused by a slowing economy rather than fiscal policies such as increasing discretionary spending or decreasing the tax rates.

Detailed Explanation:

How much of a budget deficit (or surplus) results from a change in business activity, and how much of the deficit (or surplus) results from a change in fiscal policy? Economists use the cyclically adjusted budget to evaluate the expected influence of any change in tax or spending policies on economic growth. They begin by determining what the budget deficit or surplus would be if the economy is at full-employment or long-term equilibrium. When the cyclically adjusted budget is balanced, fiscal policy is neither expansionary nor contractionary – even if the economy is running a budget deficit or surplus. The deficit or surplus results from business activity below or above the full-employment level. A fiscal policy is expansionary when there is a cyclically adjusted deficit and contractionary when there is a surplus in the cyclically adjusted budget. 

It is tempting to conclude that budget deficits always indicate the government is using an expansionary fiscal policy. However, this may not be the case. When fiscal policy results in a balanced cyclically adjusted budget, the policy is neutral, even if the economy is running a deficit. The deficit is caused by a slowing economy rather than fiscal policy. To illustrate, assume in Year 1 the economy is at full employment and the budget is balanced. The cyclically adjusted budget would equal zero. The economy slows in Year 2, resulting in a budget deficit. Tax revenues decrease as incomes fall. Several mandatory expenses that are tied to income, such as unemployment benefits and food stamps, increase because more people lose their jobs or work fewer hours. Fiscal policy is unchanged, so the cyclically adjusted budget remains balanced. The deficit was caused by a slowing economy rather than a change in fiscal policy. We would be wrong to conclude government is taking expansionary measures just because the economy is running a deficit. Assume the economy grows in Year 3 and there is a budget surplus. Again, the fiscal policy is unchanged. The cyclically adjusted budget is balanced. The surplus resulted from a growing economy. 

Dig Deeper With These Free Lessons:

The Federal Budget and Managing The National Debt
Fiscal Policy – Managing an Economy by Taxing and Spending
Business Cycles
Monetary Policy – The Power of an Interest Rate
Aggregate Supply and Demand – Macroeconomic Equilibrium