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?

ANSWER:

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.