Budget deficits have many effects,
but they all follow from single initial effects: deficits reduce national
saving. This National saving can be expressed as the sum of private saving (the
after-tax income that households save rather than consume) and public saving
(the tax revenue that the government saves rather than spends). When the
government runs a budget deficit, public saving is negative, which reduces
national savings below private saving. The effect of a budget deficit on
national saving is more likely less than one-for-one, for a decrease in public saving
produces a partially-offsetting increase in private saving. It is likely that
households spend part of this windfall but save part as well.
This implies that national savings
falls, but by less than a fall in public saving. National saving may also be
seen as the sum of investment and saving, they must reduce investment, reduce
net exports or both. The total fall in investment and net exports must exactly
match the fall in national
saving.
Budget deficits increase the trade deficit
(that is reducing net exports). Another effect is that budget deficit creates a
flow of assets abroad. This fact follows from the equality of the current account
and the capital account. When a country imports more than it exports, it does
not receive these extra goods and services for free, instead, it gives up
assets in return. Initially these assets may be the local currency, but
foreigners quickly use this money to buy corporate or government bonds, equity
or real estate. In any case, when a budget deficit turns a country into a net
importer of goods and services, the country also becomes a net exporter of
assets.
When government decides to run a
deficit, there are forces that induce firms to invest less and foreigners to
buy fewer domestic products. These forces are interest rate and exchange rate.
Interest rates are determined in the market for loans, where savers lend money
to households and firms who desire funds to invest. A decline in national
saving reduces the supply of loans available to private borrowers, which pusses
up the interest rate (the price of loan). Faced with higher interest rates,
household and firms choose to reduce investment.
Higher interest rates also affect
the flow of capital across national boundaries. When domestic assets pay higher
returns, they are more attractive to investors both at home and abroad. The
increased demand for domestic assets affects the market for foreign currency:
if a foreigner wants to buy a domestic bond, he must first acquire the domestic
current. Thus, a rise in interest rates increases the demand for the domestic
current in the market for foreign exchange, causing the currency to appreciate.
The appreciation of the currency in turn, affects trade in goods and services. With
a stronger currency, domestic goods are more expensive for foreigners, and
foreign goods are cheaper for domestic balance moves towards deficit.
Therefore, government budget deficit
reduce national saving, reduces investment, reduce net exports and creates a
corresponding flow of assets overseas. These effects occur because deficits
also raise interest rates and value of the current in the market fore foreign exchange.
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