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Macroeconomic Issues and Policies
The Effects of Spending Cuts on the Deficit

Two tools available to reduce budget deficits are tax increases and reductions in government expenditures. Efforts to reduce the budget deficit focus primarily on controlling government spending. Unfortunately, the use of either tool affects the economy in ways that make the task of reducing the deficit more difficult. Let us focus on the effects of spending cuts.

Recall that cuts in government spending are one of the tools of contractionary fiscal policy. Attempts to reduce the deficit by cutting federal spending will tend to reduce aggregate output. In an earlier lecture we learned that a decrease in aggregate output tends to increase the deficit.

The reasons, you will recall, are twofold. First, a decline in the economy reduces tax revenues for the government by reducing personal and corporate income. Second, a decline in the economy is accompanied by an increase in unemployment. This, in turn, results in increased government expenditures on unemployment and welfare programs. As a result, efforts to reduce the deficit by cutting spending will often cause the economy to react in ways that tend to make the make the deficit worse! For example, a budget cut of $20 billion is likely to reduce the deficit by much less than $20 billion if aggregate output declines sharply in the face of government spending cuts.

So, by how much will government spending need to be cut in order to reduce the deficit by, say $20 billion? That depends on how much the economy declines in the face of spending cuts and by how much the deficit will tend to go up in the face of these reactions. One measure of the latter effect is termed the deficit response index (DRI). This is a measure of how much the deficit increases for every $1 decline in GDP. The DRI has been estimated at about -0.22, meaning that a $1 billion dollar decline in GDP will increase the deficit by $0.22 billion (or $220 million). Further, the government spending multiplier must also be taken into account. If this multiplier has a value of 1.4, which is a common estimate of its magnitude, then a spending cut of $1 billion will reduce GDP by $1.4 billion. Using the value of -0.22 for the DRI, the reaction of the economy to this spending cut will have an offsetting effect equal to $0.308 billion ($1.4 billion x -0.22). Thus, a spending cut of $1 billion will actually reduce the deficit by only $692 million ($1 billion - $0.308 billion).

The point of all this is to recognize that large spending cuts are likely to be necessary to achieve a given reduction in the budget deficit. One possible way around this is for the Fed to engage in expansionary monetary policy, such as a decrease in the interest rate, at the same time the spending cuts are taking effect. Such a policy may stimulate the economy enough to diminish the reduction in GDP that would otherwise accompany the spending cuts. However, the magnitude of such expansionary monetary policy would have to be quite large.

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