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Fiscal, Monetary and Supply-Side Policy: Question 3

Syllabus 5.2

Structured AS 11 marks

The table below shows the government of Corvane's revenue and spending over two consecutive fiscal years (all figures in $ billion).

Year Government revenue Government current spending Government capital spending
Year 1 540 460 115
Year 2 560 430 115

(a) For each year, calculate Corvane's budget balance (government revenue minus total government spending) and state whether the government ran a budget deficit or a budget surplus in that year. [4]

(b) Using AD/AS analysis, explain why the change in Corvane's fiscal position between Year 1 and Year 2 represents a contractionary fiscal policy stance, and state the likely effect of this stance on the equilibrium price level and the equilibrium level of real output, holding aggregate supply constant. [4]

(c) Explain the significance of Year 1's budget position for Corvane's national debt. [3]

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Worked solution

Part (a): Budget balance in Year 1 and Year 2

Total government spending in each year is current spending plus capital spending, and the budget balance is government revenue minus total spending.

Year 1: Total spending=460+115=575\text{Total spending} = 460+115 = 575 Budget balance=540−575=−35\text{Budget balance} = 540-575 = -35

Corvane’s government spent $35 billion more than it raised in revenue, so Year 1 shows a budget deficit of $35 billion.

Year 2: Total spending=430+115=545\text{Total spending} = 430+115 = 545 Budget balance=560−545=+15\text{Budget balance} = 560-545 = +15

Corvane’s government raised $15 billion more in revenue than it spent, so Year 2 shows a budget surplus of $15 billion.

Part (b): A contractionary fiscal stance and its AD/AS effect

Between Year 1 and Year 2, government revenue rose (from $540 billion to $560 billion) while total government spending fell (from $575 billion to $545 billion, driven by lower current spending). A rise in revenue collected and a fall in G both work in the same direction: they reduce the net stimulus that fiscal policy gives to the economy. Moving from a deficit of $35 billion to a surplus of $15 billion is therefore a contractionary fiscal policy stance. Fiscal policy has been tightened.

Using AD/AS analysis, and holding the aggregate supply curve constant, this contractionary stance shifts Corvane’s AD curve to the left relative to where it would otherwise have been. This lowers both the equilibrium price level (helping to control inflation) and the equilibrium level of real output (a possible cost of the tighter stance, for example slower growth or higher unemployment).

Part (c): Significance for the national debt

A budget deficit means that government spending exceeds government revenue, so the shortfall must be financed by government borrowing (for example, by issuing government bonds). Corvane’s national debt is the total stock of past government borrowing that remains outstanding, so Year 1’s $35 billion deficit adds $35 billion to this stock. This raises the total amount Corvane’s government owes and increases the future interest payments it must make out of its budget. A recurring cost that can make it harder to reduce future deficits, unless offset by surpluses such as the one recorded in Year 2.

Final answers

  • (a) Year 1: $35 billion budget deficit; Year 2: $15 billion budget surplus
  • (b) A contractionary fiscal stance, using AD/AS analysis, this lowers both the equilibrium price level and the equilibrium level of real output
  • (c) Year 1’s deficit adds $35 billion to Corvane’s national debt, increasing future debt-interest payments