Working Paper: NBER ID: w1527
Authors: Jacob A. Frenkel; Assaf Razin
Abstract: This paper analyses the effects of fiscal policies on rates of interest and wealth in the world economy. Uncertainty concerning the length of life yields an equilibrium in which private and social rates of discount differ and budget deficits exert real effects. It is shown that a current budget deficit(resulting from a tax cut) raises world rates of interest. On the other hand the direction of the effect of an expected future deficit on the short-term rate of interest depends on whether the country is having a surplus or a deficit inits current account of the balance of payments. If it runs a deficit in the current account then the short-term rate of interest rises and vice versa; the future rate of interest, however, must rise. It is also shown that budget deficits raise domestic wealth and lower foreign wealth and thus result in a negative transmission. In the long run, a higher steady-state value of government debt raises the steady-state world rate of interest but its effect on the long-run value of foreign wealth is ambiguous. The effects of changes in government spending depend on both the timing and the patterns of spending. A transitory (balanced-budget) rise in current government spending raises the current rate of interest and lowers domestic and foreign wealth while a transitory future rise in government spending lowers the current rate of interest, lowers domestic wealth and raises foreign wealth. A permanent rise in government spending lowers the rate of interest if the current account of the balance of payments is in deficit, and vice versa. Finally, the model is generalized to a multi-commodity world and the impact of policies are shown to depend on comparison among various spending and saving propensities of private sectors and of governments.
Keywords: Fiscal Policy; Budget Deficits; Interest Rates; Wealth; International Economics
JEL Codes: E62; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| current budget deficit from tax cut (H69) | increase in world interest rates (E43) |
| increase in world interest rates (E43) | decrease in foreign wealth (F65) |
| expected future deficits (H68) | increase in domestic wealth (E21) |
| expected future deficits (H68) | decrease in foreign wealth (F65) |
| current account balance (deficit) (F32) | short-term interest rates (rise) (E43) |
| current account balance (surplus) (F32) | short-term interest rates (fall) (E43) |
| transitory balanced-budget increase in government spending (E62) | raise current interest rates (E43) |
| transitory balanced-budget increase in government spending (E62) | lower domestic wealth (D31) |
| transitory balanced-budget increase in government spending (E62) | lower foreign wealth (F29) |
| future increase in government spending (H59) | lower current interest rates (E43) |
| future increase in government spending (H59) | raise foreign wealth (F21) |
| permanent increase in government spending (surplus) (H62) | raise world interest rates (E43) |
| permanent increase in government spending (surplus) (H62) | lower wealth (D31) |
| permanent increase in government spending (deficit) (H69) | lower world interest rates (E43) |
| permanent increase in government spending (deficit) (H69) | raise foreign wealth (F21) |