Okay. Let's dig into the distinction between the structural versus cyclical deficit. This is a very important distinction because any failure on the part of government to understand this distinction can lead to very misguided macroeconomic policies and a whole lot of unnecessary pain. The structural deficit is that part of the actual budget deficit that would exist even if the economy were at full employment. It is due to the existing structure of tax and spending programs. Accordingly, the structural part of the budget is thought of as active. It is determined by discretionary fiscal policies such as those covering tax rates, public works projects and education, and defense spending. And the best way to reduce the structural budget deficit is through either increased taxes and/or a reduction in government expenditures. In contrast, the cyclical or passive deficit is that part of the actual budget deficit attributable to slow growth or recessionary economy. In fact, there are two sources of the cyclical deficit. The first is a cutback in tax revenues due to slower growth. And here, it should be obvious that if an economy is operating below its full potential, it won't be generating the revenues it needs from sales and income and other taxes tied to growth. The second source of the cyclical deficit is more subtle. It results from the increase in government payments during slow growth in recessionary periods for programs like unemployment compensation and food and housing assistance. In fact, such programs act as automatic stabilizers because they automatically act as a built-in fiscal stimulus when the nation's economy begins to slow. And note that the concept of automatic stabilizers is very much a key concept in the understanding of macroeconomic principles. Finally, know that the best way to reduce the cyclical deficit is definitely not by using contractionary fiscal and monetary policies, but rather, doing just the opposite, applying Keynesian stimuli to move the economy back to full employment. I will come back to this key point shortly, but for now, let's do a simple example to help you better understand the distinction between the cyclical and structural parts of the budget deficit. Suppose then, we assume that the gross domestic product of your country is $10 trillion and the budget deficit is $100 billion. Let's further assume that the unemployment rate is seven percent or one percent above the assumed full employment rate. For simplicity, let's also assume the absence of any counter-cyclical automatic stabilizers factoring into the equation. Finally, let's assume that the marginal income tax rate is 30 percent. This means that for every additional dollar that the GDP grows, the government will collect 30 additional cents in taxes. So, under these assumptions, I'm now going to task you with calculating which portion of the $100 billion deficit is structural and which portion is cyclical, but before you begin, let me offer you some further help here. To actually solve this problem, you are going to need a tool called Okun's law, also known as Okun's rule of thumb. Specifically, you're going to use Okun's law to calculate the increase in GDP when the economy moves back to full employment. So, just what exactly is Okun's law or Okun's rule of thumb? Okun's law is based on a famous statistical relationship observed by economist, Arthur Okun. The rule of thumb is this, for every one percent fall in the unemployment rate, a nation's gross domestic product or GDP rises by two percent. Let me repeat that. Okun's law or rule of thumb says, that for every one percent fall in the unemployment rate, GDP rises by two percent. So, based on all of the assumptions in this table, let's see if you can calculate which portion of the $100 billion deficit is structural and which portion is cyclical. Okay. Here's how we go about solving this problem. In step one, we use Okun's law to calculate the increase in the gross domestic product that would result if the unemployment rate were to fall from the existing rate of seven percent to the full employment rate of six percent. Specifically, we multiply the existing GDP of $10 trillion by the expected two percent increase in GDP that results by Okun's law from the one percent drop in the unemployment rate, and that gives us $200 billion. Now in step two, we have to calculate the additional tax revenues the government would collect from this increase in GDP. So, how much is that? Please jot down your answer quickly now before moving on. Well, at our assumed marginal tax rate of 30 percent, the additional $200 billion of GDP income would generate an additional $60 billion in tax revenues, and that is of course, the total amount of the cyclical budget deficit, because that is the amount of revenues we would gain from moving to full employment. Of course, step three, calculating the structural portion of the total deficit should be easy now. Do you see how this can quickly be done? Please try it before moving on. Step three is indeed easy. The structural portion of the total deficit is simply the total deficit of $100 billion minus the cyclical portion of the deficit of $60 billion. So, the structural deficit is $40 billion. And there you have it. So, if you've got all that right, that's great. If not, please go back and try and see where you went wrong before moving on to the next module.
