Suppose a nation’s government purchases are equal to $2 trillion, regardless of the state of the economy. However, its taxes and transfers depend on economic conditions. When the economy is at potential output, net taxes (taxes minus transfers) equal $2.2 trillion. However, for each 1 percent GDP falls below potential output, net taxes fall by 5 percent.
a. Suppose the economy was operating at potential output. What would be its budget deficit?
b. Suppose that real GDP was 5 percent below potential output. What would be its budget deficit?