Working Paper: NBER ID: w1354
Authors: Jacob A. Frenkel; Assaf Razin
Abstract: This paper deals with the international transmission of the effects of budget deficits on world rates of interest and spending. The model assumes a two-country world within which capital markets are integrated, individuals behave rationally, and the behavior of individuals and governments are governed by temporal and intertemporal budget constraints. Adopting Olivier Blanchard's formulation it is assumed that due to the probability of finite life individuals behave as if their horizon was finite. This formulation generates asimple pattern of aggregate behavior of the two-country world, and it assures that the model is not subject to the Ricardian proposition according to which budget deficits do not matter. It is shown that, for a given time path of government spending, a budget deficit raises world rates of interest and domestic wealth while it lowers foreign wealth. Thus, the deficit is transmitted negatively to the rest of the world. The channel of transmission is the world capital market and the negative transmission results from the higher rate of interest. The paper proceeds with an analysis of balanced-budget changes in government spending. It is shown that a transitory current rise in government spending raises interest rates and lowers domestic and foreign wealth while an expected future rise in government spending lowers interest rates, reduces the value of domestic wealth and raises the value of foreign wealth. The effect of a permanent rise in government spending on the rate of interest depends on whether the domestic economy is a net saver or dissaver in the world economy, i.e., if it has acurrent account surplus or deficit. If the home country runs a current account surplus then a rise in government spending raises world interest rates and lowers domestic and foreign wealth, and if the home country runs a current account deficit then a permanent balanced-budget rise in government spending lowers interest rates and domestic wealth and raises foreign wealth.
Keywords: Budget Deficits; Interest Rates; International Economics
JEL Codes: E62; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| budget deficit (H62) | world rates of interest (E43) |
| budget deficit (H62) | domestic wealth (D31) |
| budget deficit (H62) | foreign wealth (F21) |
| world rates of interest (E43) | foreign wealth (F21) |
| government spending (transitory rise) (H59) | world rates of interest (E43) |
| government spending (transitory rise) (H59) | domestic wealth (D31) |
| government spending (transitory rise) (H59) | foreign wealth (F21) |
| expected future rise in government spending (H59) | world rates of interest (E43) |
| expected future rise in government spending (H59) | domestic wealth (D31) |
| expected future rise in government spending (H59) | foreign wealth (F21) |
| current account surplus + government spending rise (E62) | world rates of interest (E43) |
| current account surplus + government spending rise (E62) | domestic wealth (D31) |
| current account surplus + government spending rise (E62) | foreign wealth (F21) |
| current account deficit + permanent rise in government spending (H69) | world rates of interest (E43) |
| current account deficit + permanent rise in government spending (H69) | domestic wealth (D31) |
| current account deficit + permanent rise in government spending (H69) | foreign wealth (F21) |