Mansouri, Kash.<\/p>\n
Here\u2019s a short lesson about something that every policy-maker should have learned in Macro 101, but apparently has been forgotten by many of them.<\/p>\n
Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US…<\/p>\n
Suppose that the country \u2013 let\u2019s call it Austerityland \u2013 has a GDP of $100\/year, and a budget deficit of $10\/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?<\/p>\n
No, the answer is not \u201ccut spending by $5\/yr\u201d. Nor is it \u201craise taxes by $5\/yr\u201d. And last but not least, it is also not \u201cenact a combination of tax increases and spending cuts that total $5\/yr\u201d. To see why, let\u2019s do just a bit of arithmetic.<\/p>\n
To keep things simple (and to make it particularly relevant to the three examples mentioned above), let\u2019s focus on the strategy of trying to halve the budget deficit primarily through spending cuts. So the government of Austerityland decides to cut spending by $5\/yr. What happens?<\/p>\n
Recall that GDP is the sum of spending on final goods and services by domestic consumers, domestic businesses, and the government, along with net exports:
\nGDP = C + I + G + (X \u2013 M) = Y. <\/em>Recall as well that GDP is, for our purposes, the same thing as income (Y).<\/p>\n