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Impact of Budget Deficit on Economic Growth

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Published: 13th Oct 2017 in Economics

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Economic Growth

The impact of the budget deficit on economic growth is theoretically explained through the effect of the deficit on the flow of money into the economy and through the supply side (infrastructure, education, etc). The more that government expenditure exceeds revenue the more money will be circulated in the economy, which leads to higher employment and output (McCandless, 1991). Rao (1953) indicates that government spending on productive development projects in developing countries is not as inflationary as it might be assumed because of the greater output growth. Eisner and Pieper (1987) report a positive impact of cyclically and inflation-adjusted budget deficit on economic growth in the United States and other Organization for Economic Cooperation and development (OECD) countries. Arora and Dua (1993) examined effect of budget deficit on investment and on trade balance in the U.S. during the period from 1980 to 1989. The results suggest that higher budget deficit crowd out domestic investment and increase trade deficit. Shojai (1999) in his study concluded that budget deficit, financed by the central bank, can also lead to ineffectiveness in financial markets and rises inflation in the developing countries. Budget deficit also pervert real exchange rates and the interest rate, which in turn undermines the international competitiveness of the economy. Recent studies, such as the World Economic Outlook (IMF, 1996); found that in the mid-1980s, a group of developing countries with high level of budget deficit had significantly lower economic growth than in countries with low and medium deficit. Karras (1994) investigated the effects of budget deficit on money growth, inflation, investment, and real output growth. Author came to conclusions that deficit do not cause high inflation through monetary expansion; deficit has a negative relationship with real output growth rate; and increased deficit do appear to slow down investment usually after one or two years. Fischer (1993) proves the opposite of theoretical prediction, on a consistent sample of countries. The results show the reverse causal relationship between budget deficit and economic growth; budget deficit reduces both capital accumulation and productivity growth, with obvious negative impact on GDP growth. Adam and Bevan (2005) investigated the relationship between budget deficit and economic growth for a group of 45 developing countries and identified that two variable have a contrary causal relationship, and a level of deficit below which causality is blurred. The results imply that reduction of budget deficit level to about 1.5% of gross domestic product is apparently has a positive impact on the growth rate of GDP. A reduction in budget deficit below this limit, not only no longer produces positive effects on economic growth, but can also actually be detrimental if the reduction is due to a significant fiscal contraction. Brauninger (2002) conducted a study on the relationship between budget deficit, public debt and endogenous growth. The result shows that if the deficit ratio fixed by the government stays below a critical level, then there are two steady states where capital and public debt grow at the same constant rate, and an increase in the deficit ratio reduces the growth rates

Trade balance

“Studies of the twin-deficits relationship generally proceed from one of two theoretical bases. The hypothesis that increases in the government’s budget deficit leads to an increase in the trade deficit follows directly from the Mundell- Fleming model (Fleming, 1962; Mundell, 1963). It is worth noting here that the Mundell-Fleming model is an open economy extension of the IS-LM model. As such, it is not fully “rational”; the assumptions made regarding expectations formation are static. According to Mundell-Fleming, an increase in the state’s budget deficit can generate an accompanying increase in the trade deficit through increased consumer spending. By increasing the disposable incomes and the financial wealth of consumers, the budget deficit encourages an increase in imports. To the extent that increased demand for foreign goods leads to depreciation in the exchange rate, the effect on net exports is mitigated. However, the larger budget deficit also pushes up the interest rate (in large open economies) because this appreciates the exchange rate, which encourages a net capital inflow and a larger decline in net exports. The size of the effect is an empirical matter (Shojai, 1999, p. 92).” (Saleh, 2003, p.13). “Fieleke (1987) provided the theoretical basis for the relationship between the budget deficit and the trade deficit. He argued that “the dominant theory is that an increase in government borrowing in a country will, other things being equal, put upward pressure on interest rates (adjusted for expected inflation) in that country, thereby attracting foreign investment. As foreign investors acquire the country’s currency in order to invest there, they bid up the price of that currency in the foreign exchange market. The higher price of the country’s currency will discourage foreigners from purchasing its goods but will conversely encourage residents of the country to use their now more valuable currency to purchase foreign goods, so that the country’s current account will move toward a deficit (or toward a larger deficit). In addition, any increase in the country’s total spending resulting from the enlarged government deficit will go partly for imports and for domestic goods that would otherwise be exported, also worsening the current account balance” (pp. 173-174).” (Saleh, 2003, p.13). Zietz and Pemberton (1990) found that the budget deficit has effect on trade deficit primarily through the impact on imports of rising domestic absorption and income, rather than through the interest and real exchange rates. The authors found that higher foreign income may play a limited role in reducing the trade deficit, especially taking into account the fact that the growth of foreign income also implies an increase in the real exchange rate. Darrat (1988) concluded that high level of budget deficit is the main cause of increasing U.S. trade deficit. Author found bidirectional relationship between two variables, where budget deficit has influence on trade deficit, but also found a stronger evidence of trade deficit impacts on budget deficit. Bernheim (1988) investigated the relationship between fiscal policy and current account among six countries United States of America, the United Kingdom, Mexico, West Germany, Canada and Japan. Author found that fiscal policy has a significant impact on trade deficit in all countries except Japan. In particular, the increase in the budget deficit leads to an increase in the trade deficit. Abell (1990) studied impact of budget deficit on trade deficit and did not find directional relationship between two variables. Author proposed that budget deficit can affect on trade deficit through interest rate, foreign capital inflow and exchange rate. In particular, when the budget deficit financing is implemented through a bond issue that could lead to higher interest rates, high interest rates attract foreign investment, foreign investment inflow trend increases the exchange rate of the national currency, strong domestic currency impacts on net exports and finally causes trade deficit. Bachman (1992) examined the factors that impact on current account deficit in U.S. The author used four variables that could conceivably be the cause of changes in current account deficit (budget deficit, investment, relative productivity and risk premium). The results imply that only the budget deficit explains the change in the current account while other not. The government should reduce budget deficit to eliminate its current account deficit. Dibooglu (1997) based on the traditional twin deficits model and the Ricardian Equivalence hypothesis, investigated the sources of the U.S. current account deficit using a several macroeconomics variables. According to the results author found the support of the traditional approach where budget deficit negatively impacts on the current account via real interest rate and terms of trade. Leachman and Francis (2002) investigated the question of the twin deficits in the U.S. in the period after World War II. The results are consistent with the twin deficits phenomenon and the evidence suggests that the direction of causality runs from the state budget deficit to a deficit of foreign sector.


Empirical studies examining the relationship between the budget deficit and inflation is not reached consensus on the possible relationship between inflation and deficit. Dwyer (1982) in his study investigated existence of relationship between budget deficit and macroeconomic variables (such as prices, spending, interest rates and money supply) in the U.S. Author checked three hypothesises (a) a deficit increases prices through a wealth effect; (b) a deficit results in debt, thus increasing the money supply and prices; and (c) expected inflation increases the deficit. The results show that, the predictable changes in government debt held by the public have no effects of debt on inflation. Also there were no evidence of that the high level of budget deficit raises price, spending, interest rates or the money supply. Hamburger and Zwick (1981) examined the effect of the budget deficit on monetary growth in the U.S. The authors came to conclusion that the combination of expansionary fiscal policy and the Federal Reserve’s efforts to control interest rates was one of the main causes tending to higher inflation. Darrat (1985) investigated effect of budget deficit on inflation in the U.S. The evidence shows that both monetary growth and budget deficit had a significant impact of inflation. Additionally author found that budget deficit has more significant impact on inflation than monetary growth. Ahking and Miller (1985) investigated the link between budget deficit, money growth and inflation. The results showed the causal but not stable relationships between variables over time. Eisner (1989) examined the impact of the budget deficit on inflationary pressures, to see if the structural deficit takes to inflation. Author found that there was no support for the proposition that budget deficit impacts on inflation. Dua (1993) investigated the relationship between long-term interest rates, government spending and budget deficit. The results show that the uncertainty of inflation and the expected growth rate of the money supply are important determinants of changes in long-term interest rates. Hondroyiannis and Papapetrou (1994) studied the impact of budget deficit on inflation in Greece. Authors came to conclusion that there is a long-term relationship between the percentage of gross domestic product and inflation in the economy. Metin (1995) studied the inflationary process in Turkey and found that fiscal expansionary policy was a main factor for inflation. “The excess demand for money affected inflation positively but only in the short-run. Imported inflation and the excess demand for assets in capital markets had some effect on consumer price inflation while there was no significant effect from the excess demand for goods. A key policy implication is that inflation could be reduced rapidly by eliminating the fiscal deficit.” (pp. 529). Metin (1998) studied the relationship between the public sector deficit, inflation, the real growth rate of income and the monetary base. The results imply that the budget deficit significantly affect inflation. Darrat (2000) in his study found that the high budget deficit has a positive and significant impact on inflation and can be a reason of inflationary effect in Greece.

Exchange Rate

Not many studies have examined the impact of the budget deficit on the value of the national currency, although there is some literature on the relationship between the current account deficit and the public budget deficit (eg, Abel, 1990). It is largely believed that the effect of short-term budget deficit on exchange rates has led to uncertainty in the nature of the relationship between two variables. Krugman (1995) and Sachs (1985) debated that lower budget deficit depreciates the value of the dollar. There is a lot of literature that contributed to many economists holding this opinion, mostly in the case of the US (Mundell, 1963; Dornbusch 1976). Evans (1986) argues that decreasing budget deficit might actually appreciate the value of the dollar in the short run. Cantor and Driskill (1995) suggest that the possibility of both short run and long run appreciation of the domestic currency in relation to public spending depends on the country’s debt. Feldstein (1986) in his study points out that appreciation of the dollar in the 1980s related to the high level of budget deficit. Wijnbergen, (1987) found a similar phenomenon Canada where budget deficit provided the appreciation of the Canadian dollar. Evans (1986) examined relationship between budget deficit and value of domestic currency, and has found no evidence of the presence of any relationship between two variables and suggests that budget deficit is a sign of weakness in the economy (and quite possibly a signal of future inflation). In another paper, Evans (1987) suggests that the high budget deficit does not necessarily lead to a strong currency. He argues that if the budget deficit affects aggregate demand, it can lead to higher price levels and, in turn, will lead to a national currency loses its value. Beck ( 1993) tests the value of the budget deficit and public spending on changes in exchange rates in five industrialized countries : United States, Germany, Japan, United Kingdom, and Canada , and believes that there is a negative relationship between budget deficits and exchange rates in all cases except Japan. Humpage (1992) examined the existence of relationship between federal budget deficit and the exchange rate in the long-run. The results show no evidence of a long-run relationship between U.S. fiscal policy and real long-term interest rates, real exchange rates of U.S. dollar, and net exports


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