Suppose waxwania is producing $600 of real gdp, whereas the potential real gdp (or full-employment real gdp) is $700. how large is its budget deficit? its cyclically-adjusted budget deficit? its cyclically-adjusted budget deficit as a percentage of potential real gdp? is waxwania’s fiscal policy expansionary or is contractionary?

Waxwania’s fiscal policy is expansionary

Explanation:

If Waxwania is producing $600 of real GDP, the budget deficit will be $40 billion ($160 (government spending at $600) – $120 (government revenue at $600)).

If potential real GDP (full employment real GDP) is $700, then the cyclically adjusted budget deficit is $20 billion (=$160 (government spending at $700) – $140 (government revenue at $700)).

Thus, the cyclically adjusted budget deficit as a percentage of potential real GDP equals 2.86 percent ($20/$700 = 0.02857 or approximately 2.86 percent).

Since the government is running a cyclically adjusted budget deficit, this fiscal policy is expansionary.  

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