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

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  • Douglas Laxton

    (International Monetary Fund)

  • Michael Kumhof

    (International Monetary Fund)

Abstract

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.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 676.

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Date of creation: 2007
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Handle: RePEc:red:sed007:676

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  1. Eric M. Engen & R. Glenn Hubbard, 2004. "Federal Government Debt and Interest Rates," NBER Working Papers 10681, National Bureau of Economic Research, Inc.
  2. Buiter, Willem H, 1981. "Time Preference and International Lending and Borrowing in an Overlapping-Generations Model," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 769-97, August.
  3. Galí, Jordi & López-Salido, David & Vallés, Javier, 2004. "Understanding the effects of government spending on consumption," Working Paper Series 0339, European Central Bank.
  4. Christophe Kamps, 2004. "New Estimates of Government Net Capital Stocks for 22 OECD Countries 1960-2001," IMF Working Papers 04/67, International Monetary Fund.
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  6. Chinn, Menzie D. & Lee, Jaewoo, 2009. "Three current account balances: A "Semi-Structuralist" interpretation," Japan and the World Economy, Elsevier, vol. 21(2), pages 202-212, March.
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  8. Galí, Jordi & Vallés, Javier & Wolman, Alexander L., 2003. "Understanding the effects of government spending on consumption," CFS Working Paper Series 2004/23, Center for Financial Studies (CFS).
  9. Caselli, Paola, 2001. "Fiscal consolidation under fixed exchange rates," European Economic Review, Elsevier, vol. 45(3), pages 425-450, March.
  10. Chinn, Menzie D. & Ito, Hiro, 2007. "Current account balances, financial development and institutions: Assaying the world "saving glut"," Journal of International Money and Finance, Elsevier, vol. 26(4), pages 546-569, June.
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  12. Olivier Blanchard & Roberto Perotti, 1999. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," NBER Working Papers 7269, National Bureau of Economic Research, Inc.
  13. Hamid Faruqee & Douglas Laxton & Dirk Muir & Paolo Pesenti, 2005. "Smooth Landing or Crash? Model-Based Scenarios of Global Current Account Rebalancing," NBER Working Papers 11583, National Bureau of Economic Research, Inc.
  14. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-47, April.
  15. Ganelli, Giovanni, 2003. "Useful government spending, direct crowding-out and fiscal policy interdependence," Journal of International Money and Finance, Elsevier, vol. 22(1), pages 87-103, February.
  16. Andrea Ferrero, 2006. "Demographic Trends, Fiscal Policy and Trade Deficits," 2006 Meeting Papers 444, Society for Economic Dynamics.
  17. Aschauer, David Alan, 1989. "Does public capital crowd out private capital?," Journal of Monetary Economics, Elsevier, vol. 24(2), pages 171-188, September.
  18. Bayoumi, Tamim & Sgherri, Silvia, 2006. "Mr Ricardo's Great Adventure: Estimating Fiscal Multipliers in a Truly Intertemporal Model," CEPR Discussion Papers 5839, C.E.P.R. Discussion Papers.
  19. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
  20. Weber, Christian E., 2002. "Intertemporal non-separability and "rule of thumb" consumption," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 293-308, March.
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