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«Stevan Gaber Working Paper No. 69 January 2010 b B A M B AMBERG E CONOMIC R ESEARCH GROUP k k* BERG Working Paper Series on Government and Growth ...»

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Economic Implications from Deficit Finance

Stevan Gaber

Working Paper No. 69

January 2010

b

B

A

M

B AMBERG

E CONOMIC

R ESEARCH

GROUP

k

k*

BERG Working Paper Series

on Government and Growth

Bamberg Economic Research Group

on Government and Growth

Bamberg University Feldkirchenstraße 21 D-96045 Bamberg Telefax: (0951) 863 5547 Telephone: (0951) 863 2547 E-mail: public-finance@uni-bamberg.de http://www.uni-bamberg.de/vwl-fiwi/forschung/berg/ ISBN 978-3-931052-77-5 Reihenherausgeber: BERG Heinz-Dieter Wenzel Redaktion Felix Stübben∗ ∗ felix.stuebben@uni-bamberg.de Economic Implications from Deficit Finance Stevan Gaber1 Department of Finance, “Goce Delcev” University, Stip, Macedonia Abstract The paper enlightens popular part of the budget policy – deficit finance. In the process of securing economic conditions to surpass the current economic crises, the governments all over the world incline towards debt deficit finance. The intention is to describe the implications such as multiplier effect, crowding out effect, correlation between budget and trade deficit. One of them are positive, they increase the aggregate demand and national income, other negative in term that they crowd out the private sector from the capital market under increased demand for loanable funds.

Keywords: Budget deficit, Crowding out, Twin deficits, Exchange rates JEL Classification: H30, H62, H63 This paper is result of three month research stay in Bamberg under Professor Dr. h. c. H.Dieter Wenzel supervision within the Tempus Project “Entrepreneurship and Local Economic Development in Albania, Kosovo and Macedonia”. Email: stevan.gaber@ugd.edu.mk.

Table of Contents 1 Introduction

2 Multiplier effect

3 “Crowding out” effect

4 “Twin Deficits”

5 Conclusion

1 Introduction In the past as today, the deficit budget policy is famous instrument of fiscal policy used to increase the rate of economic growth of the country. That way of financing was establish after the two world wars, oil crises and current financial and economic crises. There are three ways to finance the deficit – taxes, borrowing and monetization (inflation tax). The most popular model of deficit finance is borrowing, which is usually done by issue of government bonds. When the government is over indebted tends through national bank to buy government bonds which increases the money flow and reduces the interest rate pressure.

However, it diminishes the real value of money and makes the future unpredictable for the economic actors. Therefore, it is positive to conclude the debt deficit finance effects and implications that will be separately reviewed in the paper.

It’s known that nowadays the current public debt growth is larger then the growth rate of the economy for most of the industrial countries. It’s expected that the growing public debt will cause problems in perspective related to its service. The channels for public debt effect on the economy are the following: 1) direct effect on the interest rates accompanied with the necessity to sell larger supply of bonds.

As the supply of bonds intended for sale increases, their prices tend to fall, and the market interest rates go up; except if credit offer is timelessly elastic and the private borrowing is reduced. The interest rate increase can be temporary limited from the capital inflows; 2) interest rate component of the public expenditure will tend to rise, and consequently raise future fiscal deficits; 3) correlated with the previous two effects, the effect on the investment and expenditure and thus on the perspective economic performance; 4) exchange rate effect and therefore trade flows and capital movement; 5) high risk of something that may go wrong. This risk tends to rise when the total need for government borrowing caught substantial part of the total financial transactions. In that case the psychological element will have immense impact on the financial market and further on the financial stability.1 Another interest perspective of the deficit finance effects can be seen through the work of Lehman and OECD: 1) crowding out effect – it’s conventional wisdom that big and sustainable debt financed deficits raise the real interest rates under given level of savings and crowd out the private investments. The deficits can be DE LAROISERE (1984), p. 22 4 Stevan Gaber financed through decline in money balance in the private sector triggered with the higher interest rates. Therefore, at lower level then full employment, the economic activity can be increased but at expense of declining interest rate sensitive investment demand; 2) Exchange rate crowding out – interest rate pressure – especially in little open economy – will lead towards larger international capital inflows, which reduce the effect of deficit consumption on interest rate. However, in that case the domestic currency - at ceteris paribus – will potentially appreciate, and on that way impact the demand for tradable domestic goods and services. This effect is explained in the part for “Twin Deficits”; 3) Portfolio crowding out – when the government bonds participate with raising part in the private portfolio, the possession of private assets must be reduced and again puts pressure on interest rates. In other words, wealth effect has a growing influence on the fiscal effectiveness. When the saving raises, the demand for private asset (capital) and/or money balance may increase and bring to recomposition of the portfolio. Which one of these two effects will prevail, depends upon the question: Are the bonds closer portfolio substitute for money or capital? This issue is only matter of financial mix choice. According to Friedman (1978), government bonds are close substitutes for private assets, and subsequently reduce the demand for those assets.





Opposite of that, short or medium term security mainly has money characteristics, which point out that potential portfolio adjustments can have beneficial impact for private investments. At balance, that may result with “crowd in” and thus reflecting the importance of public debt management.2 These ways of finance, where the borrowing prevails, had created some doubt about the real debt condition of the countries, i.e. a lot of countries over borrowed and now are faced with the consequences. As it is familiar, IMF has the main role in implementing of desired adjustment through classical measures. The expectations are that there will be active collaboration between creditors and debtors, as the implementation of real policies of indebted countries will significantly improve their economic condition.

However, in the need to secure better economic conditions, often the government is forced to implement expansive fiscal policy, which aim is to stimulate economic actors on the market and accomplish higher level of economic growth. That kind of fiscal policy creates certain economic implications that were previously mentioned. The initial positive effect in term of economic growth is the multiplier effect, which is partially neutralized with the secondary – “crowding out” effect.

–  –  –

Also, in the text below will be look into the correlation between budget and trade deficit - “twin deficits”, reviewed through the exchange rate intermediary effect.

2 Multiplier effect The fiscal policy represents strong instrument which through public expenditure and taxes can have an influence on the aggregate demand of goods and services in the economy. The budget deficit policy, excessive public expenditure upon collected public revenues, is initiated because of economic growth impact.

Through the household and firm decisions that change the money supply or level of taxes, there is indirect impact on the aggregate demand curve. But with public expenditure intervention from the government, there is direct effect on the aggregate demand curve.

If we assume that the government made a purchase of some public good, for example plains, it will increase the aggregate demand. But is the amount of change the same as the initial public expenditure? Therefore, we are faced with two macroeconomic effects. The first, multiplier effect suggests that the movement in the aggregate demand will be bigger than the purchase, but the second one – “crowding out” suggests that the aggregate demand change will be smaller than the initial public expenditure that can be seen latter.

However, increased demand contributes with larger engagement of work force and higher profits of the company. That kind of progressive influence is transferred to the employee wages and other firm profits, which results with increase of consumption of different goods and services. So the state demand for planes increases the demand for other firm’s products in the economy. Because the increase in the aggregate demand is larger then the initial government expenditure, it is said that the government spending has multiplying effect on the aggregate demand. This implies that there is a feedback between the higher aggregate demand and the income which continuously leads towards higher demand, then again to higher income etc. All these effects imply that the total impact on demanded goods and services will be larger in respect to starting point of the government expenditure.

Also, that could initiate response from the investment side as reply to the increased demand of goods and services. That would mean additional investment in the plain company for new plant, equipment and so on. In this case, the higher government spending generates higher investment goods demand. This is known as investment accelerator.

6 Stevan Gaber Multiplier effect could be achieved from the consumer spending multiplier where the marginal propensity to consume (MPC) is the crucial element – the part of the extra income that the household consumes instead of saving it. The multiplier = 1+MPC+MPC2+MPC3+...=1/ (1-MPC). It demonstrates the demand for goods and services created upon 1 Euro of government expenditure.

The multiplier logic implies to any component of the GDP, and not only to government expenditure, as consumer spending, investment and net export. So, if it accurse decline in the net export of some country, for example, in amount of 1 million Euro, the decline in countries goods will put pressure on the national income and subsequently will reduce the domestic consumer spending. With MPC=4, the net export decline of 1 million Euro will mean contraction in aggregate demand from 4 million Euro.

This is only the first instrument of the fiscal policy, public expenditure, but there is another – taxes, which also can have impact on national income. That can be seen through the personal income tax. Reduction in this tax will increase the household income that the persons take home. One part is saved and the other is consumed. Because of consuming changes, there is movement in the aggregate demand curve to the right. Opposite, tax increase will reduce spending and move the aggregate demand curve to the left3.

Therefore, the multiplier and crowding out effect are also normal for the second instrument of fiscal policy. When the country rises spending and cuts the taxes, it causes increase in the earnings and profits, thus further is additional incentive for expenditure. That’s the multiplier effect. On the other side, higher income leads to bigger demand for money that provokes higher interest rate movement. High interest rates make the borrowing more expensive and lead toward decline in investment activity. That’s the second, crowding out effect. However, when it comes to the taxes, it’s important to take in consideration the perception of the households regarding the timely duration of tax change. In case of permanent decline of taxes, the first reaction will be larger spending caused by extra income influence and therefore larger aggregate demand. In contrary, when there is a temporary change in taxes, it will result with small impact on aggregate demand.

3 “Crowding out” effect The previous discussion is positive for the economic growth, but this effect has negative implication. This effect appears when the government borrowing steps MANKIW (2009), p. 513.

Economic implications from deficit finance 7 into the capital market with immense appétit for loanable funds which crowds out private capital investments. In the elaboration of this effect will be used national savings identity (NSI) with exemption of the foreign sector, (G-T) = (S-I), = [(G-T) + I] = S The left side from the equation represents total demand for borrowing. It’s constituted from two elements: 1) government demand for loanable funds (G-T);

and 2) private sector demand for loanable funds intended for capital investment (I). On the other side of equation is situated the supply for loanable funds, i.e.

national savings (S).

Equilibrium interest rate is set on i0, crossing point of demand and supply for loanable funds. At this interest rate level (supposable 7%) the private capital level is I0. That represents private demand for loanable funds under existing interest rates of i0.

Figure 1. “Crowding out” effect Source: LANGDANA (2009), P.

32 Therefore, under increased government borrowing for deficit finance, the total demand for capital moves to the right as it’s shown on Figure 1. That initiates interest rate to set on higher level (in the example 8, 25%). However, the higher interest rate contributes for lower private demand for capital and forming the private demand at level I1. So the private capital is crowded out by the immense government appetite for borrowing loanable funds. The amount for which the private capital is crowded out is (I0-I1).

Some economists, who favor the debt deficit finance, consider it justifiable that the capital flows linked with trade deficits should be taken into consideration, 8 Stevan Gaber because the capital flow will lower the interest rates and the crowding out effect would become bearable or ruled out. That was the case with the USA from 198487 when the deficits were financed from abroad. That situation attributed to more relaxed monetary policy beside the large budget deficit in that period of time.



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