Public Sector Deficits
Ambiguous effects

The emergence of substantial government deficits in the past decade has led to controversy over their impact on the economy. Large deficits played a part in the rapid US economic recovery in 1983-4, for example, but many observers argue that this was achieved at the cost of high real interest rates and current account deficits. In Western Europe, by contrast, large public sector deficits have not prevented rising unemployment and private investment has remained extremely weak. The existing literature on government deficits has tended either to ignore intertemporal issues or to assume that markets clear.

In Discussion Paper No. 143, Research Fellow Sweder van Wijnbergen re-examines this issue in a two-period, disequilibrium model of two open economies, each specializing in the production of a single good. The level of output depends on the capital stock and the real wage. Intertemporal optimization underlies private sector behaviour in van Wijnbergen's model; this allows the intertemporal aspects of deficits to be analysed correctly. Wages and prices are assumed to be set at the beginning of each period, at levels such that all markets will be in equilibrium if no unanticipated events subsequently occur. If such events do occur, there may be disequilibrium in labour and goods markets, within each time period. Prices are assumed to be downwardly inflexible but upwardly flexible; this marks a departure from the standard disequilibrium literature.

Van Wijnbergen shows that the effects of fiscal policy depend on whether 'Keynesian' or 'Classical' unemployment prevails. In the Keynesian case, where unemployment is the result of inadequate demand for goods, deficit spending increases output and employment. If the private sector discounts the future more heavily than the government, an increase in public expenditure will cause private consumption expenditure to increase in both the first and second periods, in spite of the private sector's complete anticipation of the increased future tax liabilities necessary to finance the deficit. Increased consumption expenditure in the second period in turn increases the value of the marginal product of capital relative to its (first-period) production costs and triggers an increase in private investment in the first period. Deficit spending under Keynesian unemployment will lead to crowding-in rather than crowding-out! The increase in private consumption expenditure, coupled with higher government deficits and increased private investment in the first period, implies that an increase in the government deficit will lead to a deterioration in the current account in the first period under Keynesian unemployment.

Under classical unemployment, however, fiscal policy has very different effects. In this regime unemployment is caused by real wages which exceed their market-clearing level, leading firms to choose low output and employment because they are insufficiently profitable. The direct effect of a fiscal expansion is to worsen the current account. Prices are flexible upwards in the model, however, and a temporary increase in government expenditure raises the price level in the first period relative to the second period. Capital goods in the first period are therefore more expensive relative to the second-period output they will produce: 'crowding-out' occurs, investment falls in the first period and the current account improves. The rise in the first-period price level relative to that in the second period also lends to make saving more attractive in the first period and so improve the current account. The net effect is ambiguous but, surprisingly, it is possible that the current account will improve.

Van Wijnbergen also notes that the more open the economy, the larger its output response and the smaller its price response to a fiscal expansion in the presence of classical unemployment. This contrasts with the Keynesian unemployment regime, where a higher import component in expenditure tends to dissipate the fiscal stimulus to aggregate demand and lead to output effects.


Government Deficits, Private Investment and the Current Account: An Intertemporal Disequilibrium Analysis
Sweder van Wijnbergen

Discussion Paper No. 143, December 1986 (IM/IT)