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Federal Reserve Bank of Cleveland ment securities, because it pays for the debt by increasing bank reserves. This in turn can would lead to even higher inflation higher interest rates. and lead to more bank lending, more money in circulation, higher demands for goods and services, and an accelerating inflation rate as both private and public sectors compete for the same resources. This problem is complicated, because all of this takes time. If inflation followed immediately on an excessive increase in bank reserves, interest rates would rise immediately to reflect the higher inflation rates, and it would not be possible for the Federal Reserve to prevent interest rates from rising by purchasing government debt. However, it takes time for an increase in bank reserves to work its way through to a higher inflation rate. During that transition period interest rates will be below their long-run marketclearing levels. The opposite happens when the trend in money-supply growth is lowered. Bank reserves are reduced immediately, shrinking the supply of credit available. Lower growth in bank reserves will lead to less lending, less money in circulation, a lower demand for goods and services, and a decelerating inflation rate. But this also takes time. During the transition period interest rates will be above their long-run market-clearing levels. Today's high interest rates reflect a reduction in the growth of bank reserves without a reduction in the underlying inflation rate. Interest rates are high, and the existence of a large budget deficit only makes interest rates higher. Increasing bank reserves to reduce interest rates could offer some shortterm relief, but it would be self-defeating; faster growth in bank reserves eventually The deficit also matters to the monetary authorities for a technical reason related to the process described earlier. The amount of interest-bearing debt outstanding can have an effect on inflation (the inverse of the value of money) if it is perceived that the taxing potential of the government is being strained and that interest-bearing debt is likely to be redeemed by inflating the money supply. In this case, deficits will raise inflation expectations and slow the adjustment process needed to end inflation. The Federal Reserve has adopted a monetary-growth rule intended to guarantee that deficits will not be financed. Most economists would agree that the steady growth rule is a reasonable if not optimal long-run policy. On the other hand, there is no well-accepted economic theory ensuring that it is reasonable or optimal to force the money supply to grow at the long-run constant rate in the short run, i.e., week-to-week or even monthto-month. But to maintain credibility and change expectations, the Federal Reserve must convince the public that it will not overshoot its long-run targets. One way to do this is to adhere to the long-run targets even in the short run. The presence of large deficits makes it more difficult to convince the public that the Federal Reserve System will not finance those deficits and places pressure on the System to adhere even more closely to its longrun targets in the short run. From a technical point of view, this is a relatively simple task. It becomes complicated, however, because the central bank is the largest trader in the money market and appears to have control over interest rates. During periods of disinflation policy, all the adjustment costs will be attributed to high interest rates and the central bank. Political coalitions will be formed by sectors in the economy that are most sensitive to high interest rates. These coalitions will often be strong, having benefited from the inflationary policies of the past. They will put pressure on the Federal Reserve to revert to an inflationary policy-although it will be called a low interest-rate or a low-unemployment policy. Conclusion Deficits can cause inflation when they are financed by excessive growth of the money supply. However, the Federal Re- serve sets growth-rate targets for the money supply that do not depend on the size of the deficit or on interest rates. These targets are intended to be low enough to reduce inflation and interest rates in the long run, although they may require higher interest rates in the short run. Large budget deficits have to be financed in credit markets, because the Federal Reserve cannot buy large amounts of government debt without creating excess bank reserves and above-target money growth. Given the money targets, a larger budget deficit will require higher interest rates to reduce private borrowings enough to float the extra government debt. July 13, 1981 f.£Q!)omic Commentary Why Do Deficits Matter? by William T. Gavin NOTE: No issues of the Economic Commentary were published in June. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland,OH 44101 Address correction requested o Correct as shown o Remove from mailing list BULK RATE U.S. Postage Paid Cleveland,OH Permit No. 385 The current budget process is likely to produce large budget deficits in fiscal year 1982 and thereafter. The budget deficit is the residual from the taxing and spending policies of the federal government. Our founding fathers gave the government the power to borrow money in article 1, section 8, of the U.S. Constitution. Without such authority the government would be forced to collect taxes priorto making expenditures. Economic theory and empirical evidence suggest that it is in the interest of the people and in the self-interest of political leaders to plan tax collections independently of exWilliam Gavin is an economist with the Federal penditures. In such a budget process there is obviously room for temporary deficits.1 The persistent and large deficits of recent years, however, have spawned intense debate about the effect of government borrowing on monetary policy and inflation. Calls for a constitutional amendment to require a balanced budget indicate that some observers believe the danger of inflation posed by large and persistent deficits outweighs the benefits of a flexible fiscal authority. In the past we often have heard opponents of proposed federal programs claim that funding these programs would cause a deficit that would lead to inflation. Today, in an apparent contradiction, many of these same ReserveBank of Cleveland. The views stated herein are those of the author 1. For a rigorous development of this theory, and not necessarily those of the Federal Reserve Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, OH 44101. see Robert J. Barro, "On the Determination of Bank of Cleveland or of the Board of Governors the Public Debt," Journal of Political Economy, of the Federal ReserveSystem. vol. 87, no. 5, part 1 (October 1979), pp. 940-71. voices are calling allowing for tax for supply-side produce cuts that, stimulus, likely to closer even would be roads, canals, or buildings, large and immediate; the costs the benefits, are deficits. A accrue slowly over a long period of time. By to issuing debt even larger and smoothing time, the the issue. costs of tax collection to future generations What Is the Deficit? from the investment and monetary policy may clarify payments The deficit tween the dollar government amount is simply because a different path services, deficits some circumstances, If we assume tax rates time, then the when there is a temporary floats finance the sector. Taxes rapid to pay for the for example, ment there of GNP. larger of debt percent of GNP, centage of size, 1940. World War II, In to vestment. like issue debt govern- that are falling. taxpayers tax rates, the taxpayer the government Given to would prefer rather than will spending rises above debt stood to 115 percent debt, had although fallen to to the prewar 1980 the 43 their whether know the this budget Debt issue levels, likely to be very federal budget policy. Since are capital in- builds schools, duct is not likely deficits governments in determining large and as the size of the debts, to inflation, Reserve state the and is budget. among and local and local to be a major factor expectations. debt only gradually. spending will above issue will be chosen result budget invest- goods, or the business cycle. deficits from deficits, war, these appear process authority services without these deficits to have re- that has used to prove direct govern- taxation. In had to be financed by or by inflating the money supply. Inflation today accelerating is the money over a period persistent result growth that of slowly that also included budget deficit deficits. represented large and In the occurred each year provision of government services for which there was no liability. extra money growth tax A little in each year had no visible connection with that year's deficit and no visible impact on inflation. was Only when accumulated over time did the long-run The level All taxes discussion spending are raised each year's a longer excess period of effects occur. so far of government government private money, takes spending actual as optimal. "crowds out" to degree. When to pay for spending, the credit If the credit interest the to the private If the Federal banking system, immediately, does then private and ducing If the policy prices and persist, will policy, lead to crowding out of inflation private loans. government spending depends ment's on will ac- marginal value of the duct. sector the is too value high of the relative rises. and the output has been tive to private-sector output enlarges tax reductions deficits that Why the deficit matters of authorities or too conflicting govern- officials. A stable to thought the can be seen govern- growing rela- for 100 years promises of by They judge the value of marto be low rela- judgments government about the spending. appropriate level If government-pro- Federal more that seemingly give up current consumption. at the services to sell its debt directly the the Federal Reserve; immediate kets, and interest However, the the Part in debt raised promise another the on debt in full. The debt can only grow if more of lenders (savers) current consumption. can be found As the to Therefore, debt maintain the the the Reserve valuable because promise standard, the Federal agency) money to deficit.3 to re- in full is its commitment paper the market value of the currency. current which open of the government's pay the the promises to Under dollar U.S. government Reserve is (of is an indepen- to limit the quantity in circulation. 3. In fact, since bought to repay ex- A problem can Reserve buys govern- to then borrows in the credit market. implicit pro- of the current arise when the Federal represents Act from buy- Federal in the absorb the equivalent services debt have Reserve amounts. is whether of But government not from the U.S. Treasury dent the difference would Reserve System if both are not take mar- Federal hibits the Federal deficits and taxes this rates Persistent provided, would off the credit pressure raise taxes. Government to for the government to not to kept. anyone When interest it might seem tempting also are made are in can buy govern- requiring Promises promises lender might be willing to acquire enough additional suggests occur bor- rates are very high, government A trend toward government private is one without debt question to con- expenditures more in the cur- out Reserve future. promise-an depends force the economy government promise may actually tive to private-sector production. An evaluation of the deficit to re- in the past may be in the future. government promises the made trend pay for them. The government be arguing against more govern- or to ing debt directly by looking a higher to rise fu rther. to the monetary of as an implicit level more, to give up consumption period The if they result The Deficits and Monetary Policy are production of the public are meant suggests that many who argue against deficits ginal government because and be paid to induce cept in very limited and a particular That may support (relative to private output) temporary higher as output will differ occur that programs tinue the trend falls programs that more must ment Their judgments, that borrow rate rowers at the margin. we rely Those who place a low value on gov- ernment pro- from is not Those who place a high spending pro- consumers Instead, on values increased marginal to ment-sector depend the value of marginal private-sector's output test. citizens. deficits from rent process to reflect the evalua- temporary sector. people of duce the role of the public sector. investment product In general, duction in turn, be a non- borrowing rates Whether the on the political tions of individual may support accommodating interest consumption low with up, thus re- government higher for this market value on government demand celerate, and interest rates will rise. If the Federal Reserve follows inflationary suited to interest judgment government with each individual. as surely as if taxes had been deficits yet most collective to the credit will compete to force incomes raised. to save. buyers; the rates may not rise services demand monetary forcing out of the mar- but the government's goods not of tries produced this evaluation result and would goods and services, system, adds interest priced the banking more people Reserve were the banking ket as well as inducing services with privately Reserve borrowers and sold in competition effect rates will rise immediately, marginal goods Reserve does into Federal duced government if the Federal extra ment spending. the spending some add When the "crowding-out" only inject system. for policy. from a political borrowing spend- departure federal not borrowing the but past in public ment the ex- in government finance did Ex post, at some so that lower. Tax rates will begin to be of the sulted monetary does not con- of state or inflation and project in state the deficits likely States. relationship operations inflation at the relative Federal are not United trend not of government as a temporary however, is obvious. borrows explicit to be a reason investment the deficits, open-market government an examines the in the common because was well cumulative is more article we have to in income as All fall issue may arise from public-invest- programs, for federal or effect underlying be lowered immediately general, To determine trends the trend collections is desirable, expenditures and local tax trends. expected duration government its long-run and a deficit government ment whenever long-run This firms, to finance income per- of GNP. private When a government debt below rise to and partial ment level in the future, in the optimal the the levels of government seen trend, in- want issue debt generally 2. While debt of expenditures. $715.1 billion, or 27 percent likely military of the federal equal to but not by enough equivalent in absolute Governments, is a tem- of the 1963 federal By in gov- government In 1946 the level of government at $241.9 billion, to rise when and tax collections assumption whenever 50 percent exceeded spending often the desired deficit During deficits structure, lowered Current be an the extra spending. increase buildup war. long-run Viewed in this context, amount are raised, cause government smooth pected and the is going ing becomes programs, income-tax that benefit such as unemployment welfare Suppose time Institu- if determination is obvious known that This change. spending raise tax rates to finance federal a large arrangements, trend. complicated the tax fall during recessions. income-sensitive that but spreads also may issue debt when compensation, our minimizes over in income. the tional only will issue debt or when a war usually constant government porary decrease for that taxpayers to be fairly spending than tax collections comes to plan for expenditures prefer During and the dollar allow the government tax collections. ernment federal Temporary under they the be- on goods, payments. desirable that in taxes it spends and transfer are amount collects that the difference A government not trends rates over proiects.f inflation government tax from becomes however, and its relation look at the deficit departure forego government as little percent of the 1965, the Federal as 2 percent annual Reserve has and as much as 150 growth of Treasury debt. Since the Accord of 1951, the general presumption has been that the Federal more general encompass tionary than the monetary Reserve's financing need for a flexible policy. objectives Treasury debt. were They but noninfla- voices are calling allowing for tax for supply-side produce cuts that, stimulus, likely to closer even would be roads, canals, or buildings, large and immediate; the costs the benefits, are deficits. A accrue slowly over a long period of time. By to issuing debt even larger and smoothing time, the the issue. costs of tax collection to future generations What Is the Deficit? from the investment and monetary policy may clarify payments The deficit tween the dollar government amount is simply because a different path services, deficits some circumstances, If we assume tax rates time, then the when there is a temporary floats finance the sector. Taxes rapid to pay for the for example, ment there of GNP. larger of debt percent of GNP, centage of size, 1940. World War II, In to vestment. like issue debt govern- that are falling. taxpayers tax rates, the taxpayer the government Given to would prefer rather than will spending rises above debt stood to 115 percent debt, had although fallen to to the prewar 1980 the 43 their whether know the this budget Debt issue levels, likely to be very federal budget policy. Since are capital in- builds schools, duct is not likely deficits governments in determining large and as the size of the debts, to inflation, Reserve state the and is budget. among and local and local to be a major factor expectations. debt only gradually. spending will above issue will be chosen result budget invest- goods, or the business cycle. deficits from deficits, war, these appear process authority services without these deficits to have re- that has used to prove direct govern- taxation. In had to be financed by or by inflating the money supply. Inflation today accelerating is the money over a period persistent result growth that of slowly that also included budget deficit deficits. represented large and In the occurred each year provision of government services for which there was no liability. extra money growth tax A little in each year had no visible connection with that year's deficit and no visible impact on inflation. was Only when accumulated over time did the long-run The level All taxes discussion spending are raised each year's a longer excess period of effects occur. so far of government government private money, takes spending actual as optimal. "crowds out" to degree. When to pay for spending, the credit If the credit interest the to the private If the Federal banking system, immediately, does then private and ducing If the policy prices and persist, will policy, lead to crowding out of inflation private loans. government spending depends ment's on will ac- marginal value of the duct. sector the is too value high of the relative rises. and the output has been tive to private-sector output enlarges tax reductions deficits that Why the deficit matters of authorities or too conflicting govern- officials. A stable to thought the can be seen govern- growing rela- for 100 years promises of by They judge the value of marto be low rela- judgments government about the spending. appropriate level If government-pro- Federal more that seemingly give up current consumption. at the services to sell its debt directly the the Federal Reserve; immediate kets, and interest However, the the Part in debt raised promise another the on debt in full. The debt can only grow if more of lenders (savers) current consumption. can be found As the to Therefore, debt maintain the the the Reserve valuable because promise standard, the Federal agency) money to deficit.3 to re- in full is its commitment paper the market value of the currency. current which open of the government's pay the the promises to Under dollar U.S. government Reserve is (of is an indepen- to limit the quantity in circulation. 3. In fact, since bought to repay ex- A problem can Reserve buys govern- to then borrows in the credit market. implicit pro- of the current arise when the Federal represents Act from buy- Federal in the absorb the equivalent services debt have Reserve amounts. is whether of But government not from the U.S. Treasury dent the difference would Reserve System if both are not take mar- Federal hibits the Federal deficits and taxes this rates Persistent provided, would off the credit pressure raise taxes. Government to for the government to not to kept. anyone When interest it might seem tempting also are made are in can buy govern- requiring Promises promises lender might be willing to acquire enough additional suggests occur bor- rates are very high, government A trend toward government private is one without debt question to con- expenditures more in the cur- out Reserve future. promise-an depends force the economy government promise may actually tive to private-sector production. An evaluation of the deficit to re- in the past may be in the future. government promises the made trend pay for them. The government be arguing against more govern- or to ing debt directly by looking a higher to rise fu rther. to the monetary of as an implicit level more, to give up consumption period The if they result The Deficits and Monetary Policy are production of the public are meant suggests that many who argue against deficits ginal government because and be paid to induce cept in very limited and a particular That may support (relative to private output) temporary higher as output will differ occur that programs tinue the trend falls programs that more must ment Their judgments, that borrow rate rowers at the margin. we rely Those who place a low value on gov- ernment pro- from is not Those who place a high spending pro- consumers Instead, on values increased marginal to ment-sector depend the value of marginal private-sector's output test. citizens. deficits from rent process to reflect the evalua- temporary sector. people of duce the role of the public sector. investment product In general, duction in turn, be a non- borrowing rates Whether the on the political tions of individual may support accommodating interest consumption low with up, thus re- government higher for this market value on government demand celerate, and interest rates will rise. If the Federal Reserve follows inflationary suited to interest judgment government with each individual. as surely as if taxes had been deficits yet most collective to the credit will compete to force incomes raised. to save. buyers; the rates may not rise services demand monetary forcing out of the mar- but the government's goods not of tries produced this evaluation result and would goods and services, system, adds interest priced the banking more people Reserve were the banking ket as well as inducing services with privately Reserve borrowers and sold in competition effect rates will rise immediately, marginal goods Reserve does into Federal duced government if the Federal extra ment spending. the spending some add When the "crowding-out" only inject system. for policy. from a political borrowing spend- departure federal not borrowing the but past in public ment the ex- in government finance did Ex post, at some so that lower. Tax rates will begin to be of the sulted monetary does not con- of state or inflation and project in state the deficits likely States. relationship operations inflation at the relative Federal are not United trend not of government as a temporary however, is obvious. borrows explicit to be a reason investment the deficits, open-market government an examines the in the common because was well cumulative is more article we have to in income as All fall issue may arise from public-invest- programs, for federal or effect underlying be lowered immediately general, To determine trends the trend collections is desirable, expenditures and local tax trends. expected duration government its long-run and a deficit government ment whenever long-run This firms, to finance income per- of GNP. private When a government debt below rise to and partial ment level in the future, in the optimal the the levels of government seen trend, in- want issue debt generally 2. While debt of expenditures. $715.1 billion, or 27 percent likely military of the federal equal to but not by enough equivalent in absolute Governments, is a tem- of the 1963 federal By in gov- government In 1946 the level of government at $241.9 billion, to rise when and tax collections assumption whenever 50 percent exceeded spending often the desired deficit During deficits structure, lowered Current be an the extra spending. increase buildup war. long-run Viewed in this context, amount are raised, cause government smooth pected and the is going ing becomes programs, income-tax that benefit such as unemployment welfare Suppose time Institu- if determination is obvious known that This change. spending raise tax rates to finance federal a large arrangements, trend. complicated the tax fall during recessions. income-sensitive that but spreads also may issue debt when compensation, our minimizes over in income. the tional only will issue debt or when a war usually constant government porary decrease for that taxpayers to be fairly spending than tax collections comes to plan for expenditures prefer During and the dollar allow the government tax collections. ernment federal Temporary under they the be- on goods, payments. desirable that in taxes it spends and transfer are amount collects that the difference A government not trends rates over proiects.f inflation government tax from becomes however, and its relation look at the deficit departure forego government as little percent of the 1965, the Federal as 2 percent annual Reserve has and as much as 150 growth of Treasury debt. Since the Accord of 1951, the general presumption has been that the Federal more general encompass tionary than the monetary Reserve's financing need for a flexible policy. objectives Treasury debt. were They but noninfla- voices are calling allowing for tax for supply-side produce cuts that, stimulus, likely to closer even would be roads, canals, or buildings, large and immediate; the costs the benefits, are deficits. A accrue slowly over a long period of time. By to issuing debt even larger and smoothing time, the the issue. costs of tax collection to future generations What Is the Deficit? from the investment and monetary policy may clarify payments The deficit tween the dollar government amount is simply because a different path services, deficits some circumstances, If we assume tax rates time, then the when there is a temporary floats finance the sector. Taxes rapid to pay for the for example, ment there of GNP. larger of debt percent of GNP, centage of size, 1940. World War II, In to vestment. like issue debt govern- that are falling. taxpayers tax rates, the taxpayer the government Given to would prefer rather than will spending rises above debt stood to 115 percent debt, had although fallen to to the prewar 1980 the 43 their whether know the this budget Debt issue levels, likely to be very federal budget policy. Since are capital in- builds schools, duct is not likely deficits governments in determining large and as the size of the debts, to inflation, Reserve state the and is budget. among and local and local to be a major factor expectations. debt only gradually. spending will above issue will be chosen result budget invest- goods, or the business cycle. deficits from deficits, war, these appear process authority services without these deficits to have re- that has used to prove direct govern- taxation. In had to be financed by or by inflating the money supply. Inflation today accelerating is the money over a period persistent result growth that of slowly that also included budget deficit deficits. represented large and In the occurred each year provision of government services for which there was no liability. extra money growth tax A little in each year had no visible connection with that year's deficit and no visible impact on inflation. was Only when accumulated over time did the long-run The level All taxes discussion spending are raised each year's a longer excess period of effects occur. so far of government government private money, takes spending actual as optimal. "crowds out" to degree. When to pay for spending, the credit If the credit interest the to the private If the Federal banking system, immediately, does then private and ducing If the policy prices and persist, will policy, lead to crowding out of inflation private loans. government spending depends ment's on will ac- marginal value of the duct. sector the is too value high of the relative rises. and the output has been tive to private-sector output enlarges tax reductions deficits that Why the deficit matters of authorities or too conflicting govern- officials. A stable to thought the can be seen govern- growing rela- for 100 years promises of by They judge the value of marto be low rela- judgments government about the spending. appropriate level If government-pro- Federal more that seemingly give up current consumption. at the services to sell its debt directly the the Federal Reserve; immediate kets, and interest However, the the Part in debt raised promise another the on debt in full. The debt can only grow if more of lenders (savers) current consumption. can be found As the to Therefore, debt maintain the the the Reserve valuable because promise standard, the Federal agency) money to deficit.3 to re- in full is its commitment paper the market value of the currency. current which open of the government's pay the the promises to Under dollar U.S. government Reserve is (of is an indepen- to limit the quantity in circulation. 3. In fact, since bought to repay ex- A problem can Reserve buys govern- to then borrows in the credit market. implicit pro- of the current arise when the Federal represents Act from buy- Federal in the absorb the equivalent services debt have Reserve amounts. is whether of But government not from the U.S. Treasury dent the difference would Reserve System if both are not take mar- Federal hibits the Federal deficits and taxes this rates Persistent provided, would off the credit pressure raise taxes. Government to for the government to not to kept. anyone When interest it might seem tempting also are made are in can buy govern- requiring Promises promises lender might be willing to acquire enough additional suggests occur bor- rates are very high, government A trend toward government private is one without debt question to con- expenditures more in the cur- out Reserve future. promise-an depends force the economy government promise may actually tive to private-sector production. An evaluation of the deficit to re- in the past may be in the future. government promises the made trend pay for them. The government be arguing against more govern- or to ing debt directly by looking a higher to rise fu rther. to the monetary of as an implicit level more, to give up consumption period The if they result The Deficits and Monetary Policy are production of the public are meant suggests that many who argue against deficits ginal government because and be paid to induce cept in very limited and a particular That may support (relative to private output) temporary higher as output will differ occur that programs tinue the trend falls programs that more must ment Their judgments, that borrow rate rowers at the margin. we rely Those who place a low value on gov- ernment pro- from is not Those who place a high spending pro- consumers Instead, on values increased marginal to ment-sector depend the value of marginal private-sector's output test. citizens. deficits from rent process to reflect the evalua- temporary sector. people of duce the role of the public sector. investment product In general, duction in turn, be a non- borrowing rates Whether the on the political tions of individual may support accommodating interest consumption low with up, thus re- government higher for this market value on government demand celerate, and interest rates will rise. If the Federal Reserve follows inflationary suited to interest judgment government with each individual. as surely as if taxes had been deficits yet most collective to the credit will compete to force incomes raised. to save. buyers; the rates may not rise services demand monetary forcing out of the mar- but the government's goods not of tries produced this evaluation result and would goods and services, system, adds interest priced the banking more people Reserve were the banking ket as well as inducing services with privately Reserve borrowers and sold in competition effect rates will rise immediately, marginal goods Reserve does into Federal duced government if the Federal extra ment spending. the spending some add When the "crowding-out" only inject system. for policy. from a political borrowing spend- departure federal not borrowing the but past in public ment the ex- in government finance did Ex post, at some so that lower. Tax rates will begin to be of the sulted monetary does not con- of state or inflation and project in state the deficits likely States. relationship operations inflation at the relative Federal are not United trend not of government as a temporary however, is obvious. borrows explicit to be a reason investment the deficits, open-market government an examines the in the common because was well cumulative is more article we have to in income as All fall issue may arise from public-invest- programs, for federal or effect underlying be lowered immediately general, To determine trends the trend collections is desirable, expenditures and local tax trends. expected duration government its long-run and a deficit government ment whenever long-run This firms, to finance income per- of GNP. private When a government debt below rise to and partial ment level in the future, in the optimal the the levels of government seen trend, in- want issue debt generally 2. While debt of expenditures. $715.1 billion, or 27 percent likely military of the federal equal to but not by enough equivalent in absolute Governments, is a tem- of the 1963 federal By in gov- government In 1946 the level of government at $241.9 billion, to rise when and tax collections assumption whenever 50 percent exceeded spending often the desired deficit During deficits structure, lowered Current be an the extra spending. increase buildup war. long-run Viewed in this context, amount are raised, cause government smooth pected and the is going ing becomes programs, income-tax that benefit such as unemployment welfare Suppose time Institu- if determination is obvious known that This change. spending raise tax rates to finance federal a large arrangements, trend. complicated the tax fall during recessions. income-sensitive that but spreads also may issue debt when compensation, our minimizes over in income. the tional only will issue debt or when a war usually constant government porary decrease for that taxpayers to be fairly spending than tax collections comes to plan for expenditures prefer During and the dollar allow the government tax collections. ernment federal Temporary under they the be- on goods, payments. desirable that in taxes it spends and transfer are amount collects that the difference A government not trends rates over proiects.f inflation government tax from becomes however, and its relation look at the deficit departure forego government as little percent of the 1965, the Federal as 2 percent annual Reserve has and as much as 150 growth of Treasury debt. Since the Accord of 1951, the general presumption has been that the Federal more general encompass tionary than the monetary Reserve's financing need for a flexible policy. objectives Treasury debt. were They but noninfla- Federal Reserve Bank of Cleveland ment securities, because it pays for the debt by increasing bank reserves. This in turn can would lead to even higher inflation higher interest rates. and lead to more bank lending, more money in circulation, higher demands for goods and services, and an accelerating inflation rate as both private and public sectors compete for the same resources. This problem is complicated, because all of this takes time. If inflation followed immediately on an excessive increase in bank reserves, interest rates would rise immediately to reflect the higher inflation rates, and it would not be possible for the Federal Reserve to prevent interest rates from rising by purchasing government debt. However, it takes time for an increase in bank reserves to work its way through to a higher inflation rate. During that transition period interest rates will be below their long-run marketclearing levels. The opposite happens when the trend in money-supply growth is lowered. Bank reserves are reduced immediately, shrinking the supply of credit available. Lower growth in bank reserves will lead to less lending, less money in circulation, a lower demand for goods and services, and a decelerating inflation rate. But this also takes time. During the transition period interest rates will be above their long-run market-clearing levels. Today's high interest rates reflect a reduction in the growth of bank reserves without a reduction in the underlying inflation rate. Interest rates are high, and the existence of a large budget deficit only makes interest rates higher. Increasing bank reserves to reduce interest rates could offer some shortterm relief, but it would be self-defeating; faster growth in bank reserves eventually The deficit also matters to the monetary authorities for a technical reason related to the process described earlier. The amount of interest-bearing debt outstanding can have an effect on inflation (the inverse of the value of money) if it is perceived that the taxing potential of the government is being strained and that interest-bearing debt is likely to be redeemed by inflating the money supply. In this case, deficits will raise inflation expectations and slow the adjustment process needed to end inflation. The Federal Reserve has adopted a monetary-growth rule intended to guarantee that deficits will not be financed. Most economists would agree that the steady growth rule is a reasonable if not optimal long-run policy. On the other hand, there is no well-accepted economic theory ensuring that it is reasonable or optimal to force the money supply to grow at the long-run constant rate in the short run, i.e., week-to-week or even monthto-month. But to maintain credibility and change expectations, the Federal Reserve must convince the public that it will not overshoot its long-run targets. One way to do this is to adhere to the long-run targets even in the short run. The presence of large deficits makes it more difficult to convince the public that the Federal Reserve System will not finance those deficits and places pressure on the System to adhere even more closely to its longrun targets in the short run. From a technical point of view, this is a relatively simple task. It becomes complicated, however, because the central bank is the largest trader in the money market and appears to have control over interest rates. During periods of disinflation policy, all the adjustment costs will be attributed to high interest rates and the central bank. Political coalitions will be formed by sectors in the economy that are most sensitive to high interest rates. These coalitions will often be strong, having benefited from the inflationary policies of the past. They will put pressure on the Federal Reserve to revert to an inflationary policy-although it will be called a low interest-rate or a low-unemployment policy. Conclusion Deficits can cause inflation when they are financed by excessive growth of the money supply. However, the Federal Re- serve sets growth-rate targets for the money supply that do not depend on the size of the deficit or on interest rates. These targets are intended to be low enough to reduce inflation and interest rates in the long run, although they may require higher interest rates in the short run. Large budget deficits have to be financed in credit markets, because the Federal Reserve cannot buy large amounts of government debt without creating excess bank reserves and above-target money growth. Given the money targets, a larger budget deficit will require higher interest rates to reduce private borrowings enough to float the extra government debt. July 13, 1981 f.£Q!)omic Commentary Why Do Deficits Matter? by William T. Gavin NOTE: No issues of the Economic Commentary were published in June. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland,OH 44101 Address correction requested o Correct as shown o Remove from mailing list BULK RATE U.S. Postage Paid Cleveland,OH Permit No. 385 The current budget process is likely to produce large budget deficits in fiscal year 1982 and thereafter. The budget deficit is the residual from the taxing and spending policies of the federal government. Our founding fathers gave the government the power to borrow money in article 1, section 8, of the U.S. Constitution. Without such authority the government would be forced to collect taxes priorto making expenditures. Economic theory and empirical evidence suggest that it is in the interest of the people and in the self-interest of political leaders to plan tax collections independently of exWilliam Gavin is an economist with the Federal penditures. In such a budget process there is obviously room for temporary deficits.1 The persistent and large deficits of recent years, however, have spawned intense debate about the effect of government borrowing on monetary policy and inflation. Calls for a constitutional amendment to require a balanced budget indicate that some observers believe the danger of inflation posed by large and persistent deficits outweighs the benefits of a flexible fiscal authority. In the past we often have heard opponents of proposed federal programs claim that funding these programs would cause a deficit that would lead to inflation. Today, in an apparent contradiction, many of these same ReserveBank of Cleveland. The views stated herein are those of the author 1. For a rigorous development of this theory, and not necessarily those of the Federal Reserve Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, OH 44101. see Robert J. Barro, "On the Determination of Bank of Cleveland or of the Board of Governors the Public Debt," Journal of Political Economy, of the Federal ReserveSystem. vol. 87, no. 5, part 1 (October 1979), pp. 940-71. Federal Reserve Bank of Cleveland ment securities, because it pays for the debt by increasing bank reserves. This in turn can would lead to even higher inflation higher interest rates. and lead to more bank lending, more money in circulation, higher demands for goods and services, and an accelerating inflation rate as both private and public sectors compete for the same resources. This problem is complicated, because all of this takes time. If inflation followed immediately on an excessive increase in bank reserves, interest rates would rise immediately to reflect the higher inflation rates, and it would not be possible for the Federal Reserve to prevent interest rates from rising by purchasing government debt. However, it takes time for an increase in bank reserves to work its way through to a higher inflation rate. During that transition period interest rates will be below their long-run marketclearing levels. The opposite happens when the trend in money-supply growth is lowered. Bank reserves are reduced immediately, shrinking the supply of credit available. Lower growth in bank reserves will lead to less lending, less money in circulation, a lower demand for goods and services, and a decelerating inflation rate. But this also takes time. During the transition period interest rates will be above their long-run market-clearing levels. Today's high interest rates reflect a reduction in the growth of bank reserves without a reduction in the underlying inflation rate. Interest rates are high, and the existence of a large budget deficit only makes interest rates higher. Increasing bank reserves to reduce interest rates could offer some shortterm relief, but it would be self-defeating; faster growth in bank reserves eventually The deficit also matters to the monetary authorities for a technical reason related to the process described earlier. The amount of interest-bearing debt outstanding can have an effect on inflation (the inverse of the value of money) if it is perceived that the taxing potential of the government is being strained and that interest-bearing debt is likely to be redeemed by inflating the money supply. In this case, deficits will raise inflation expectations and slow the adjustment process needed to end inflation. The Federal Reserve has adopted a monetary-growth rule intended to guarantee that deficits will not be financed. Most economists would agree that the steady growth rule is a reasonable if not optimal long-run policy. On the other hand, there is no well-accepted economic theory ensuring that it is reasonable or optimal to force the money supply to grow at the long-run constant rate in the short run, i.e., week-to-week or even monthto-month. But to maintain credibility and change expectations, the Federal Reserve must convince the public that it will not overshoot its long-run targets. One way to do this is to adhere to the long-run targets even in the short run. The presence of large deficits makes it more difficult to convince the public that the Federal Reserve System will not finance those deficits and places pressure on the System to adhere even more closely to its longrun targets in the short run. From a technical point of view, this is a relatively simple task. It becomes complicated, however, because the central bank is the largest trader in the money market and appears to have control over interest rates. During periods of disinflation policy, all the adjustment costs will be attributed to high interest rates and the central bank. Political coalitions will be formed by sectors in the economy that are most sensitive to high interest rates. These coalitions will often be strong, having benefited from the inflationary policies of the past. They will put pressure on the Federal Reserve to revert to an inflationary policy-although it will be called a low interest-rate or a low-unemployment policy. Conclusion Deficits can cause inflation when they are financed by excessive growth of the money supply. However, the Federal Re- serve sets growth-rate targets for the money supply that do not depend on the size of the deficit or on interest rates. These targets are intended to be low enough to reduce inflation and interest rates in the long run, although they may require higher interest rates in the short run. Large budget deficits have to be financed in credit markets, because the Federal Reserve cannot buy large amounts of government debt without creating excess bank reserves and above-target money growth. Given the money targets, a larger budget deficit will require higher interest rates to reduce private borrowings enough to float the extra government debt. July 13, 1981 f.£Q!)omic Commentary Why Do Deficits Matter? by William T. Gavin NOTE: No issues of the Economic Commentary were published in June. Federal Reserve Bank of Cleveland Research Department P.O. Box 6387 Cleveland,OH 44101 Address correction requested o Correct as shown o Remove from mailing list BULK RATE U.S. Postage Paid Cleveland,OH Permit No. 385 The current budget process is likely to produce large budget deficits in fiscal year 1982 and thereafter. The budget deficit is the residual from the taxing and spending policies of the federal government. Our founding fathers gave the government the power to borrow money in article 1, section 8, of the U.S. Constitution. Without such authority the government would be forced to collect taxes priorto making expenditures. Economic theory and empirical evidence suggest that it is in the interest of the people and in the self-interest of political leaders to plan tax collections independently of exWilliam Gavin is an economist with the Federal penditures. In such a budget process there is obviously room for temporary deficits.1 The persistent and large deficits of recent years, however, have spawned intense debate about the effect of government borrowing on monetary policy and inflation. Calls for a constitutional amendment to require a balanced budget indicate that some observers believe the danger of inflation posed by large and persistent deficits outweighs the benefits of a flexible fiscal authority. In the past we often have heard opponents of proposed federal programs claim that funding these programs would cause a deficit that would lead to inflation. Today, in an apparent contradiction, many of these same ReserveBank of Cleveland. The views stated herein are those of the author 1. For a rigorous development of this theory, and not necessarily those of the Federal Reserve Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, OH 44101. see Robert J. Barro, "On the Determination of Bank of Cleveland or of the Board of Governors the Public Debt," Journal of Political Economy, of the Federal ReserveSystem. vol. 87, no. 5, part 1 (October 1979), pp. 940-71.
@FedFRASER