First, define and explain the cyclically adjusted deficit. Second, explain what effect a recession caused, for example, by a reduction in consumer confidence will have on the size of the cyclically adjusted deficit.

What will be an ideal response?


The cyclically adjusted deficit is the deficit that would occur if the economy were operating at the natural level of output. In terms of notation, it would be represented as G – T0 – tYN where T0 is autonomous taxes, YN is the natural level of output, and t is the average income tax rate. Deviations in output from YN will not cause changes in the cyclically adjusted deficit. So, a consumption-led recession will have no effect on this particular measure of the budget.