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short essays and reports on the economic issues of the day
2004 ■ Number 6

Budget Deficits and Interest Rates
Edward Nelson
n February 2, 2004, President Bush released his
budget proposals for fiscal year 2005, along with
an estimate of the 2004 budget deficit of $521 billion. The return of substantial deficits has reignited debate
on the implications of budget deficits for the economy.
Warnings about the consequences of U.S. budget deficits,
while not new, have shifted in emphasis over time. During
the 1970s, emphasis was on the inflationary consequences
of deficits. For example, in 1975, Ronald Reagan stated that
inflation “has one cause and one cause alone: government
spending more than government takes in.” By contrast, the
concern voiced since the 1980s about deficits rests on the
argument that they put upward pressure on real interest rates.
Deficits can be a source of inflation if they are accommodated by monetary policy—that is, if higher deficits provoke
an increase in money growth. This can occur if the securities
issued by the government to finance deficits are purchased
by the central bank. It also occurs if the securities are sold
to the private sector, but the central bank then attempts to
offset any resulting upward pressure on interest rates. Under
either scenario, the occurrence of deficits leads to greater
money growth, creating excess aggregate demand and
inflationary pressure.
The present-day emphasis on the implications of the
deficit for interest rates, and not inflation, reflects an expectation that the Federal Reserve will not accommodate
deficits with money creation, but instead will allow nominal
and real interest rates to rise to whatever levels are consistent
with keeping aggregate demand and inflation under control.
This expectation reflects the experience since 1982, during
which inflation has been controlled despite several years of
high deficits (including fiscal year 1983’s $208 billion deficit
of approximately 6 percent of GDP, above the 4.5 percent
estimated for 2004). This experience confirms that monetary policy is capable of keeping inflation low even in the
face of large changes in the government’s budgetary position.
To see how deficits might matter for interest rates, it is
useful to remember that nominal interest rates are the sum
of an expected inflation component and a real rate of return.


A non-accommodative monetary policy stance implies that
the expected-inflation component of nominal rates will be
unchanged in the face of higher deficits. But it also implies
that monetary policy will not resist any upward pressure
on real interest rates that arises from greater government
Why might real interest rates rise in response to deficit
financing? With monetary accommodation of the deficit
ruled out, the government needs to induce the private sector
to increase its subscriptions to government bonds. If the
private sector’s volume of saving has not increased one-forone with the higher deficit, extra government borrowing
must take place at the expense of the financing of private
projects, such as investment in residences or factory equipment. Real interest rates rise as the government attracts
funds away from these sources. The higher interest rate has
the effect of reducing the private sector’s demand for capital,
which is thus brought down in line with the reduced supply
of saving available for private use. The lower private capital
accumulation underlies what Douglas Holtz-Eakin, the
director of the Congressional Budget Office, has summarized as a “modestly negative” effect of budget deficits on
long-term economic potential.
Much empirical evidence for the United States has found
little relation between deficits and interest rates. However,
a recent study1 does detect a “statistically and economically
significant” relationship between higher deficit projections
and expected future long-term interest rates, after controlling
for other factors that determine real interest rates, including
the long-term rate of economic growth. According to the
author’s estimates, an increase in the projected deficit-toGDP ratio of 1 percentage point “raise[s] long-term interest
rates by roughly 25 basis points.” These estimates suggest
that if the deficit-to-GDP ratio were sustained at present
levels, the eventual result would be real interest rates 1 percentage point higher than would prevail under a balanced
budget. ■

Laubach, Thomas. “New Evidence on the Interest Rate Effects of Budget Deficits
and Debt” Finance and Economics Discussion Series Paper No. 2003-12, Board
of Governors of the Federal Reserve System, May 2003.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.