A Party without a Hangover? On the Effects of U.S. Government Deficits

This paper develops a 2-country non-Ricardian overlapping generations model suitable for the joint evaluation of monetary and fiscal policies. Ricardian equivalence does not hold because of consumers with finite economic lifetimes and lifecycle income that are myopic with respect to future tax liabilities. We use the model to investigate the implications of a permanent increase in government deficits and debt in the U.S. and find that such a policy results in significant crowding-out effects both in the U.S. and the rest of the world by reducing world savings and raising the world real interest rate. It also leads to a very sizeable U.S. current account deterioration, especially in the medium and long term. We critique conventional models that rely on the infinite horizon model and show that such models are ill-equipped to deal with fiscal issues that involve permanent changes in government debt. In addition our model offers more sensible predictions regarding the effects of changes in government infrastructure investment expenditures, which have very different effects from the conventionally assumed wasteful government expenditures. Finally we study the effects of lower U.S. and higher rest of the world private sector savings rates. The latter is a candidate explanation for the currently observed low world real interest rates despite very large U.S. current account deficits.