Government Deficits, Private Investment and the Current Account: An Intertemporal Disequilibrium Analysis

We use a model with full intertemporal optimization and short-run rigidities in the real wage of the Fischer-Gray type to demonstrate the effects of deficit spending in different employment regimes. We allow for prices to exhibit upward flexibility, although once set at the beginning of one period they will be downwardly rigid until the beginning of the next period. We show that, conditional on a plausible assumption about public and private sector discount rates, under Keynesian unemployment deficit spending reduces unemployment, improves the future terms of trade and therefore leads to an increase in private investment (crowding-in) and to a deterioration of the current account. Under classical unemployment, goods markets clear but unemployment persists because of contract-based real wage rigidity. Fiscal expansion then goes partly into prices (terms of trade improvement) and only partly into quantities. The latter occurs to the extent that contract based real consumption wage rigidity, coupled with a terms of trade improvement, allows a lower real product wage. A temporary increase in government expenditure in classical unemployment leads to a bigger terms of trade improvement today than tomorrow, so both income and substitution effects lead to a current account improvement. The cost of capital increases more than the value of future output and investment falls. This also improves the first period current account. The direct impact of increased first period government expenditure may offset these surprising positive effects on the first period current account. Finally we show that the more open the economy is, the larger is the output response and the smaller the price response to a fiscal expansion in the presence of classical unemployment. This contrasts with the Keynesian unemployment regime, where a higher import component in expenditure leads to more dissipation of effective demand and smaller output effects.