Widening Budget Deficits and Investment Growth Dynamics

This chapter explored the impact of positive budget deficit shocks on investment growth and employment growth, and whether the interest rate, business and consumer confidence channels amplify or dampen these effects. We find that investment growth and employment growth decline due to positive budget deficit shocks, whereas the current account deficit and inflation increase. The results suggest that higher budget deficits tend to crowd out domestic investment, lower employment growth, and increase the trade deficit and inflation. Furthermore, we establish that the interest rates increase, and the business and consumer confidence indices decline. The results indicate that the budget deficit leads to higher inflation and higher interest rates, and that investment and employment growth decline. Firms and households become concerned by future tax implications of the fiscal deficit, the level of debt and debt service costs. The policy implications are that policymakers must adopt good fiscal management policies that avoid the crowding-out effects of investment while preserving business and consumer confidence.