In the standard
model, there is an assumption that the substitution of a budget deficit for
current taxation leads to an expansion of aggregate consumer demand. In other
words, desired private saving rises by less than the tax cut, so that desired
national saving declines. In a closed economy, the expected real interest rate
would have to rise to restore equality between desired national saving and
investment demand. The higher real interest rate crowds out investment, which
shows up in the long-run as a smaller stock of productive capital. Therefore,
in the language of Franco Modigliani (1986) the public debt is an
inter-generational burden that it leads to a smaller stock of capital for future
generation.
In an open
economy, a small country’s budget deficits would have negligible effects on the
real interest rate international capital markets. Therefore, in the standard
analysis, the home country’s decision to substitute budget deficits for current
taxes leads mainly to increased borrowing from abroad, rather than to a higher
real interest rate. That is, budget deficits leads to current account deficits.
Expected real interest rates rise for the home country only if it is large
enough to influence world markets or if the increased national debt induces on
this country’s obligations. In any event, there is a weaker tendency for a
country’s budget deficits to crowd up in the long run as a stock of nation
wealth and correspondingly higher claims for foreigners.
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