The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Economic Review
Federal Reserve Bank of Dallas
January 1984
1
The Strong Dollar,
the Current Account,
and Federal Deficits:
Cause and Effect
Leroy O. Laney
The international repercussions of budget deficits
have been quite topical recently. Current account
deficits can be linked increasingly to fiscal deficits
in the United States. Statistical investigations
show this relationship to hold more tightly for the
smaller and developing economies with thinner
capital markets. But when deficits grow large
enough, even an economy such as the United States
depends more on foreign funds for government
finance .
15
How Fiscal Policy Matters
John Bryant
In the long run, increases in the size of government
normally reduce the aggregate production of goods
and services, primarily through the effect on the
economy's efficiency and on people's perceptions
of their wealth. Because of administrative costs and
the incentive-reducing effects of taxes and transfer
payments, the government's expansion is generally
exceeded by a private sector contraction. Also, the
mix of tax and bond financing may temporarily
affect perceived wealth and, therefore, demand . An
increase in government spending financed by bond
sales will encourage consumption at the expense of
investment if taxpayers underestimate the future tax
payments required to payoff the bonds. This lowers
the future capital stock and potential output.
Neither effect requires a rise in interest rates.
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
The Strong Dollar,
the Current Account,
and Federal Deficits:
Cause and Effect
By Leroy O. Laney*
The U.S. economy enters 1984 under a more
desirable confluence of circumstances than in some
time. A consumer recovery is under way, inflation
and inflationary expectations are lower, business
profits are increasing to provide an underpinning for
investment, and unemployment is falling steadily.
Three factors mar this scene, however. The exchange rate of the dollar hovers around all-time
highs, hurting U.S. export competitiveness. The current account of the balance of payments is in
record deficit and is expected to get much worse,
acting as a drag on U.S. output and jobs. Finally, the
federal budget is also in record deficit. Thought by
many observers to be the most serious problem facing the economy today, budget deficits may worsen
in future years, risking higher interest rates and
* Leroy O. Laney is an assistant vice president
and senior economist at the Federal Reserve Bank
of Dallas. The views expressed are those of the
author and do not necessarily reflect the
positions of the Federal Reserve Bank of Dallas
or the Federal Reserve System.
Economic Review/January 1984
renewed stagnation just beyond the near-term
horizon.
This article examines in some detail these three
factors and some causal relationships among them.
Does the budget deficit's influence on U.S. interest
rates cause an "overvalued" dollar that, in turn,
drives the current account into deficit? To what extent is the current account deficit simply an external reflection of this budget deficit, and to what
extent do the capital inflows that finance the external deficit also help to finance the fiscal deficit?
Historically for the United States, budget deficits
and current account deficits have occurred together
relatively infrequently. Empirical investigations
presented in this article show the linkage between
the fiscal balance and the external balance to be
much tighter for the smaller developing countries
than for industrial economies, especially the United
States. For advanced economies, private savings and
more-developed capital markets can cushion the impact of fiscal policy on the balance of payments.
If budget deficits grow very large relative to the
total economy, however, no country is immune. It
seems the United States has now reached and
passed the point at which the budget deficit's ef-
fects are felt on the external side, and there are no
immediate signs that a correction is forthcoming.
Exc"ange rate strength
\
Perh~ps the most visible symptom recently has been
the ~ice of the U.S. currency in foreign exchange
mark ts. It may be somewhat difficult to argue that
the .S. macropol icy mix has hurt our economy
grea Iy until now, given recent overall economic
performance. But on the international side the case
is more clear-cut. An expansionary fiscal policy
combined with nonaccommodative monetary policy
puts upward pressure on interest rates, underpinning
a strong exchange rate that drives the balance of
trade further into deficit. Without the external
deficit, the economy's ascent from the recent recession would have been more spectacular than it has
been. The dollar's strength- its alleged "overvaluation" - has revived arguments in some quarters
about appropriate policy actions for a remedy.
Some of these policy recommendations, however,
focus on actions other than alteration of the
underlying policy mix.
After weakness that extended from 1978 through
1980, the U.S. dollar entered a period of strength in
foreign exchange markets that has endured into
1984 (Chart 1). The trade-weighted average value of
the dollar reached a post-1973 low in October 1978,
just before the announcement of the dollar-support
package that promised increased official intervention and borrowing in foreign currencies to bolster
U.S. reserves. The dollar remained relatively
lackluster, however, until near the end of 1980,
when it began a dramatic rise that took it to record
levels for the floating rate period. As 1983 drew to a
close, the trade-weighted index for the currency
stood over 30 percent above its level when
generalized floating began almost 11 years earlier.
Even after adjustment for domestic and foreign inflation since the inception of floating, the index was
over 20 percent higher.
After more than a decade of floating, there continues to be an interesting absence of consensus
among economists on exchange rate policy. Disregarding a still more or less maverick contingent
that would opt for an international gold standar9's
absolutely fixed rates ("fixed" at least until countries pursuing economic policies at variance with
others' find intermittent adjustments to exchange
rates necessary), disagreement remains as to how
2
much official manipulation of exchange rates is
desirable or even possible. The spectrum has at one
extreme those who would eschew official intervention entirely. They believe the private market is
always right or at least that central bankers are no
better able to conduct profitable, and therefore
stabilizing, speculation than is the private market.
At the other extreme are those who believe that exchange rates alternately overshoot and undershoot
equilibrium levels. These individuals occasionally
advocate systematic and sometimes massive official
intervention to restore a more appropriate exchange
rate. Those now arguing that the dollar is substantially overvalued are largely the same ones who
were convinced it was undervalued in the late
1970s.
If an exchange rate overadjusts and remains away
from an equilibrium level for a prolonged period,
the implications are serious, even for a large
economy such as the United States. Earlier in the
floating rate period, there was concern that excessive exchange rate volatility would add to uncertainties of conducting international transactions and
ultimately dampen world trade and financial flows.
A more recent concern emphasizes short-term volatility less than longer-term basic misalignment of
exchange rates. Such misalignment can give inappropriate price signals and impose serious resource
reallocation costs on domestic economies. As
resources are wrenched back and forth in response
to inappropriate price signals, it is argued, high frictional unemployment and other costs are generated.
There can also be significant spillovers into a country's trade policy, as protectionist pressures mount
and artificial trade measures are advocated.'
Throughout the managed floating rate period, it
has usually been the policy of most central banks to
"lean against the wind" in an effort to dampen
swings in exchange rates, without any effort to
judge whether rates are moving toward or away
from equilibrium on their own momentum. Advo-
1. There is not much accumulated evidence, however, that
resource reallocation costs of exchange rate fluctuations have
been as great as feared by many early critics of floating. For
an in-depth treatment, see Paul R. Fiacco, Leroy O. Laney,
Marie C. Thursby, and Thomas D. Willett, "Exchange Rates
and Trade Policy," Contemporary Policy Issues, no. 4, Papers
from the 1983 Western Economic Association International
Conference (Huntington Beach, Calif., January 1984),6-18.
Federal Reserve Bank of Dallas
Chart 1
Nominal and Real Trade-Weighted Exchange Values of the
u.s.
Dollar
(MARCH 1973=100)
135
125
115
105
100
95
85
75
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
SOURCE: Board of Governors, Federal Reserve System.
cates of a more activist posture toward intervention would point out that such leaning against the
wind can actually retard restoration of equilibrium
if an overadjusting rate when left alone demonstrates a tendency to move back toward
equilibrium eventually.
For the past several years the United States has
2. From early 1981 through the end of 1983, the recognized
Federal Reserve-U.S. Treasury foreign exchange operations
were attributed to the following causes: the Reagan assassination attempt in March 1981; a European Monetary System
realignment in June 1982; events surrounding an emerging international debt crisis, plus possibly other causes, in August
and October 1982; upward movement in the dollar along with
unsettled markets, perhaps associated with then-perceived U.S.
interest rate expectations, in late July and early August 1983;
and a modest purchase of yen (in coordination with Japanese
authorities sensitive to international criticism about yen under-
Economic Review/January 1984
adopted a minimalist strategy toward exchange rate
intervention, effecting a presence in the market only
in extraordinary circumstances when the market is
perceived to be disorderly by some definition. 2
There has been absolutely no aggressive effort to
move the exchange rate to some preconceived level
by intervention alone. When the United States has
intervened, the scale has always been very small
valuation), to prevent excessive weakening of that currency in
response to a Bank of Japan discount rate cut, on October 31
and November 1, 1983. On each of these occasions, foreign exchange operations were quite minor compared with U.S. intervention before 1981 and relative to foreign intervention
conducted concurrently during the period. See the reports on
Treasury and Federal Reserve foreign exchange operations that
are published in various issues of the Federal Reserve Bulletin
each year.
3
relative to total flows through the market in a given
period.
While the private market is usually quite sensitive
to official attitudes as manifested by foreign exchange intervention, the efficacy of intervention
depends on the ability to convince traders that it is
profitable to join on the central bank's side of the
market. A skeptical market that opposes official efforts may view those efforts as an open admission
by authorities that the exchange rate has a built-up
momentum in the opposite direction, so taking
the other side of the market presents that most
desirable of circumstances-a certain bet.
The recent official U.S. stance has been underpinned by a philosophy that while official foreign
exchange operations might be useful in providing
volume and reducing short-term volatility in unsettled or thin markets, they have very little longterm effect in changing the level of the exchange
rate. This is especially true if such intervention is accompanied by other domestic and international
macroeconomic policies that are not in harmony
with exchange rate objectives. 3 To move the exchange rate to a new level in the longer run, national monetary and fiscal policies must be geared
toward or at least compatible with that goal.
Because U.S. intervention is routinely sterilizedthat is, its effect on non borrowed reserves is
neutralized by opposite domestic open market
operations- no change in overall monetary policy
is encompassed in foreign exchange operations. 4
At a superficial level, passive and activist views
on intervention posture can be reconciled. It is
3. These views were given official articulation in the "Report of
the Working Group on Exchange Market Intervention" (March
1983), a study prepared by representatives from major central
banks and treasuries, commissioned by the Versailles Summit
of the Heads of State and Government in June 1982.
4. Nonsterilized intervention changes the currency composition
of world money, while sterilized intervention changes the currency composition of world non money financial assets. If
securities denominated in different currencies are perfect substitutes, sterilized intervention cannot be effective; its efficacy
depends on the extent to which these assets are imperfect
substitutes. This issue is not totally resolved. Some empirical
evidence, however, shows that while nonsterilized intervention
has a strong effect on the exchange rate, sterilized intervention has very little. See Maurice Obstfeld, "Exchange Rates,
I nflation, and the Steril ization Problem: Germany, 1975-1981,"
European Economic Review 21 (March-April 1983): 161-89.
4
tautological to say that the private market always
sets the rate that instantaneously clears the market,
and in this sense the market is always right. Those
who make a case for overvaluation or undervaluation usually refer to underlying factors of exchange
rate determination. These factors generally include
trends in domestic and foreign money growth, income growth, expected inflation rates, real interest
rates, and the balance of payments. 5 Recent empirical work has shown that state-of-the-art exchange
rate models including such factors are no better at
out-of-sample prediction than forward rates or a random walk, even when using actual values for explanatory variables in the post-sample period. 6 Is
the dollar, then, truly overvalued by standards conventionally used to judge this issue?
The current account
Chief among the factors in the present environment
that are mentioned to support a claim for dollar
overvaluation is a large and increasing current account deficit in the balance of payments. Recent
U.S. current account developments seem to have
played very little part in dollar exchange rate
behavior. The current account-which includes net
investment income, tourism, transportation receipts,
and some other flows as well as merchand ise
trade-is the most comprehensive measure of the
balance of payments usually computed or analyzed
in a flexible exchange rate environmenU This
measure of the external balance, after registering
only a modest surplus in 1980 and 1981, began a
sharp deterioration into deficit in mid-1982 (Table 1).
The dollar did not follow the current account
down, at least apparently deriving its strength
5. For a recent treatment of the development of exchange rate
literature over the floating rate interval and for policy and
historical perspectives, see Jeffrey R. Shafer and Bonnie E.
Loopesko, "Floating Exchange Rates After Ten Years," Brookings Papers on Economic Activity, 1983, no. 1 :1-70.
6. See Richard A. Meese and Kenneth Rogoff, "Empirical Exchange Rate Models of the Seventies: Do They Fit Out of
Sample?" Journal of International Economics 14 (February
1983): 3-24.
7. Broader definitions of the external balance including capital
flows, such as the "basic balance" and the "official reserve
transactions balance," were discontinued with the advent of
flexible exchange rates because they were judged to be irrelevant and sometimes even misleading in such an environment.
Federal Reserve Bank of Dallas
Table 1
U.S. BALANCE OF PAYMENTS
(Seasonally adjusted)
1982
Q1
Q2
1983
Q3
Q4
Item
Merchandise trade balance.
Current account balance.
Net capital flows
Errors and omissions
Q1
Q2
Q3p
Millions of dollars
-$6,103
-$5,854
-$13,078
-$11,354
-$8,810
-$14,661
-$18,169
564
1,434
-6,596
-6,621
-3,587
-9,655
-11,976
-4,332
-9,322
-8,486
-8,036
-5,217
10,298
12,058
3,768
7,887
15,082
14,657
8,833
-644
-82
p- Preliminary.
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
elsewhere. Of course, it is by now well established
that goods markets do not clear as quickly as exchange markets. But it is useful to remember also
that the overall balance of payments is an accounting identity that always sums to zero after the fact.
Any current account deficit materializing in a given
period must be balanced by a corresponding net
capital inflow from abroad.
The array of accounts in the balance of payments
tells an economist nothing about causation. It is just
as easy, however, and in the short run just as correct in analyzing effects on the exchange rate, to
conceive of causation running from the bottom up
as from the top down. From this perspective, financial flows are not the passive reaction to an
autonomous current account; rather, the current account is driven by exogenous capital flows. Capital
inflows can strengthen the exchange rate, make exports less competitive abroad and imports cheaper
domestically, and combine with a host of other factors to widen the current account deficit" Because
capital flows can be quite volatile, the exchange
rate may also demonstrate short-run volatility. But
even for a very long time the exchange rate may
8. It would, of course, also be incorrect and overly simplistic to
ignore completely the effect the current account has on the
exchange rate. Over the longer haul, persistent and large current account deficits or surpluses are quite likely to cause
exchange rate adiustment, even though the response may be
subject to a considerable lag.
Economic Review/January 1984
deviate substantially from a level that would
balance the current account.
Capital flows are likely to be driven by economic
forces that are traditionally considered in exchange
rate determination. But they may originate from
sources that are not captured in conventional
economic models. Political instabilities as well as
economic uncertainties, for example, can cause certain currencies to attract funds seeking a haven.
Recently, there has been little doubt that the U.S.
dollar has been a preferred currency for flight
capital, particularly from Mexico and other Latin
American countries. It is impossible to capture all
of this capital flight in balance-of-payments transactions, but the errors and omissions account has
sometimes been large enough in recent periods to
finance the total U.S. trade deficit. Errors and omissions have diminished sharply, however, turning
negative in m id-1983.
Although most of this statistical discrepancy is
thought to be composed of unrecorded capital
transactions, a substantial share may also derive
from incomplete recording of some transactions
belonging in the current account-yet another
reason why this balance may be a misleading indicator of the appropriate exchange rate. The
United States, as well as other countries, seems better able to monitor external payments on the current account than external receipts, particularly in
the services component.
These measurement problems accumulate across
countries. Theoretically, the sum of the current ac5
count surpluses and deficits of all countries should
add to zero because the world economy is a closed
system. But in 1982 no major group of countries
recorded a surplus. The missing global surplus that
year has been estimated to be $80 billion to $100
billion." From a policy standpoint, it is worth noting
that this discrepancy can lead to an overly restrictive stance globally, possibly also increasing protectionist pressure.
How undesirable overall are a strong dollar and a
current account deficit for the United States? The
picture is not totally one-sided. A strong dollar
reflects the world's confidence in this country-a
change indeed from the situation only a few years
ago when private and official diversification out of
the dollar as a reserve currency was a major concern.'o A strengthening currency also means less
inflationary pressure from abroad because imports
are becoming cheaper in domestic terms. A current
account deficit means this country is able to consume more goods and services from abroad than it
exports to pay for them and also may mean less inflationary pressure because more real goods and
services are entering the country than are leaving it.
On balance, however, the state of affairs is
detrimental. Abnormal dollar strength hurts U.S.
competitiveness, damaging some otherwise healthy
industries and possibly causing inefficient allocation
of real resources. The current account deficit causes
the accumulation of foreign debt owed by the
United States to foreigners, draining scarce capital
from the rest of the world. A more appropriate role
for the United States, as one of the world's wealthiest countries, is net lender rather than net borrower. Throughout most of the postwar period, this
net-lender role was fulfilled while the United States
9. This global discrepancy can result from timing as well as the
fact that certain transactions escape the record. The lapse between exporting-country shipment and importing-country
receipt can lead to distortion in periods when world trade
values are changing rapidly.
10. See Leroy O. Laney, "A Diminished Role for the Dollar as a
Reserve Currency?" Voice of the Federal Reserve Bank of
Dallas, December 1978, 11-23.
11. The role of the United States as the world's principal reserve
currency country has always made likely a short-term capital
inflow over time as foreign countries accumulate international reserves. Earlier in the postwar interval, a typical configuration was a current account surplus combined with a
(,
usually ran current account surpluses."
While causal linkages here are a slippery issue,
causation appears to run more from the exchange
rate to the current account than vice versa, in the
short term at least. (At present, of course, other
things than a strong dollar influence the current account deficit-for example, the income effects of
faster economic growth in the United States than
abroad.) But the coexistence of the two and the
absence of clearly defined causation suggest there
might be a third force underlying them both.
Federal budget deficits
There is another U.S. deficit in today's picture, the
federal budget deficit. This deficit has received
more attention than the deficit in the balance of
payments. Recent heated policy debate has
centered on the inflationary impact of budget
deficits, whether it makes a difference if the deficits
are monetized, whether the deficits are related to
higher interest rates through crowding out of private
investment in capital markets, and - perhaps foremost-the urgency and methods of reducing these
deficits relative to other goals, such as low taxes
and a strong national defense. Compared with the
case of the strong dollar or the current account
deficit, however, there is probably more agreement
that the present and prospective federal deficits are
unambiguously bad.
Some observers have recently alluded to a causal
linkage from the federal deficit to the strong dollar
and the current account deficit.'2 The argument
generally runs as follows. Actual and expected large
budget deficits cause relatively high real interest
rates in the United States, which strengthens the
dollar. Dollar strength, in turn, exacerbates the cur-
larger long-term capital outflow. The resulting balance-ofpayments deficit, financed by short-term inflows, occasionally
gave rise to charges that the United States was able to exploit
its seigniorage advantage-that is, to run a secular payments
deficit to satisfy the world's growing demand for international
reserves. But on the capital account alone, the United States
as reserve center provided liquidity to the world by functioning as a global intermediary, borrowing short and lending
long.
12. See, for example, Economic Report of the President, February
1984, together with The Annual Report of the Council of
Economic Advisers (Washington, D.C.: Government Printing
Office, 1984).
Federal Reserve Bank of Dallas
Chart 2
Net Foreign Capital Flows, U.S. Budget Deficit, and Total Net Savings
BILLIONS OF DOllARS
225 ~-----------------------------------------------------------------,
200
175
,
,,,
,
,,,
,,,
TOTAL NET SAVINGS
150
FEDERAL DEFICIT
NET FOREIGN CAPITAL flOWS
125
100
I
I
75
t-1
I,
I ,
",
I
,
,
\
50
,
,I
25
,1
\ ...
/
:
I
",
I
I
\,
r-, "
~
0
-25
1945
SOURCE:
u.s.
1950
1955
1960
1965
1970
1975
1980
1985
Department of Commerce, Bureau of Economic Analysis
rent account deficit. The current account deficit is
therefore the mirror image of the domestic budget
deficit, with foreign capital inflows to finance the
former also helping to finance the latter.
It is important to note several things about these
relationships over the long haul. First, it would require a massive current account deficit indeed to
take much of a bite out of federal financing needs,
even if foreign flows are important at the margin. As
a source of net savings in the United States, the net
foreign capital inflow is usually relatively small
(Chart 2). Net private savings, followed at some
distance by the state and local budget surplus, provide the bulk of overall U.S. net savings. The contribution from abroad not only is typically much
smaller than either of these two but also is
frequently negative, corresponding to an external
Economic ReviewlJanuary 1984
payments surplus. A net capital outflow from this
country has preyailed in most postwar years. As a
use of net savings, on the other hand, the federal
deficit has become quite significant recently.
A somewhat different picture is shown by the
foreign-held share of total outstanding Treasury
debt, 12.5 percent at the end of 1982.13 But this
substantial share is larger than the contribution
usually made by net foreign inflows in any given
period. Of the total foreign share, the largest proportion is held by foreign central banks and other
13. Larger shares were held by domestic households (24.4 percent)
and government trust funds (17.5 percent). Approximately
equal shares were held by Federal Reserve banks (11.7 percent) and commercial banks (11.2 percent).
7
official monetary authorities. The foreign share grew
significantly during the 1970s, with official dollar
purchases by monetary agencies of the oilproducing countries as well as by central banks of
industrial countries. It was suggested in the 1970s
that energy-related developments increased the
demand for dollar-denominated instruments by
redistributing wealth to oil-producing countries that
have higher net saving. This impact is likely to be
more important in times when these countries accumulate reserves from oil price escalations. A
major rise in oil prices is not in the present scenario,
nor is it a near-term prospect. Official purchases by
industrial countries are much more prevalent when
the dollar is fall ing, as major-currency cou ntries
seek to moderate the rise of their currencies against
the U.S. monetary unit.14
A second observation deals with the role of
deficits in inflationary expectations. Looming huge
deficits may presage high nominal interest rates but
not high real ones because if deficit-associated inflationary expectations mushroom, real interest rates
might not be so high. And experience has shown
that it is real interest rates that are important in influencing the exchange rate. It may be believed that
budget deficits are not inflationary in themselves,
and apparently one must also have faith that they
will not be indiscriminately monetized. The adoption several years ago of a more disciplined
monetary stance by the Federal Reserve, plus the
Fed's vocal opposition to future deficits, probably
does help underpin an assumption that excessive
monetization is not forthcoming. But it is a crucial
assumption. The longer-term historical record suggests that exchange rate behavior and expectations
can be very sensitive to central bank independence
from the government agency that sets fiscal
policy.'s
balance-of-payments deficits, a country does not
have a capital inflow because it has a current
account deficit; it has a current account deficit
because it has a capital inflow, and it has a capital
inflow because it has a budget deficit. Simultaneous
occurrence is of little general use in determining
causal direction, as always. Resort to a national income accounting framework helps illustrate this.
Where, as traditionally defined, Y is gross national
product, C is private consumption, I is private investment, G is government expenditures, X is exports
of goods and services, M is imports of goods and
services,S is private savings, and T is government
taxation:
(1)
Y = C
+I+
G
+
(X -
M) = C
+
5
+
T.
Then, rearranging terms,
(2)
(M -
X)
=
(I -
5)
+
(G -
T).
The external deficit must equal the difference in
private investment and private savings plus the difference in government expenditures and taxation,
the fiscal deficit.
If causation always runs unidirectionally from the
fiscal deficit to the external deficit, from the
government sector to the foreign sector, then the
private sector surplus or deficit must be stable over
time. While this is a rather heroic assumption when
savings and investment functions are viewed in a
Keynesian framework, the relationship between the
fiscal deficit and the external deficit can be tested
by estimating
(3)
(M - X) =
Q'
+
(3(G -
T),
where the constant term Q' represents (I - 5).
It is impossible, however, for this causal relationship to hold for all countries. This can be illustrated
with a theoretical two-country world, composed
only of Countries A and B. Assume that in Country
A the budget deficit is transmitted to the external
balance:
A third point, returning to the causation issue,
relates to the earlier discussion of current accountcapital flow causation. If fiscal deficits cause
(4)
14. This mechanism provides a source of current account deficit
finance in such periods. Because the current account
responds to a depreciating dollar only with a lag (initially,
the falling currency may only increase import values and
decrease export values, volume changes coming later), this
finance may be needed. But if large enough, official foreign
inflows could indeed help retard the dollar's fall, as intended.
15. See, for example, Joseph Bisignano, "The Lesson of
Poincare," Weekly Letter, Federal Reserve Bank of San
Francisco, 8 July 1983. For a cross-country survey of central
bank independence that also compares and discusses the
role of exchange rate behavior, see King Banaian, Leroy O.
Laney, and Thomas D. Willett, "Central Bank Independence:
An International Comparison," Economic Review, Federal
Reserve Bank of Dallas, March 1983, 1-13.
8
Federal Reserve Bank of Dallas
But Country A's external deficit is, by definition,
Country B's external surplus because global
surpluses and deficits must sum to zero:
(5)
(Ma -
Xa) = -(Mb -
Xb ) = (X b -
M b )·
If Country A's budget deficit unidirectionally causes
its external deficit, it must be able to force this
deficit on the rest of the world, here composed only
of Country B. In Country B, then, causation must
run the other direction. Its external surplus must
unidirectionally cause a budget surplus:
(6)
I n a world of n countries, therefore, the
hypothesized causal direction can hold for n-1
at most. The nth country will always be forced to
conduct a fiscal policy dictated by the sum of the
external balances of the rest of the world. And
the fact that the relationship cannot hold for one
country raises a question as to whether it does not
hold for a larger number.
The real world is not so simple, of course. Actual
causation is likely to be bidirectional in many countries, even though it may run predominantly in one
direction or another. It is possible to hypothesize
the countries in which causation runs more from the
domestic to the foreign side and those in which it
runs more from the foreign to the domestic side. A
relatively small and open economy, for which international transactions are very important, would be
more likely to have domestic developments dictated
by the foreign balance. A large economy for which
foreign trade is less important would probably have
its external balance conform to domestic policy.
Even for the smaller economies, however, it is more
logical and usually more realistic to conceive of
causation running from the domestic side to the
foreign side.
For more-developed economies, the relationship
may not hold systematically at all. The configuration of private investment and savings may absorb
the effect of fiscal policy without transmitting it to
the external balance.
An international survey
It is possible to examine the relationship of the
fiscal balance to the external balance, as stated
quite simply in equation 3 above, over a wide range
of diverse countries. Results of such an investigation
are subject to some rather apparent caveats. CoeffiEconomic Review/January 1984
cients may be biased by simultaneity, and with
respect to specification there is obviously a wide array of other variables besides the fiscal deficit that
would enter an equation purporting to explain more
fully the movements of the current account. But the
exercise at least can determine whether there is any
correspondence between the two balances, and time
series analysis affords the summarization of a very
large amount of data. Examination of results not
only can indicate the international prevalence of
this correspondence but also may shed light on the
kinds of countries for which it is likely to hold most
strongly.
In Table 2, industrial and developing countries
are grouped according to I nternational Monetary
Fund classification. Data limitations made it
necessary to exclude a number of IMF member
countries, but results for 59 countries in all are
shown.
The fiscal balance as a determinant of the external balance is statistically significant noticeably
more frequently in the developing-country group
than in the industrial-country group. Even within the
industrial-country group, it is in the smaller
economies that the variable shows significance.
Among the world's seven largest economies, only
Canada and Italy demonstrate a statistically significant positive relationship. The United States evinces
a negative (perhaps spurious) relationship that
would be judged significant at the same statistical
level if that were the test being conducted.
Although simultaneity bias may vary across countries, coefficient size is generally larger for the
smaller and less-developed economies, illustrating
that the external balance is larger relative to the
fiscal balance in those cases.
The outcomes for the smaller and developing
economies are not surprising, given the common
knowledge that both external deficits and fiscal
deficits of these countries are frequently financed
largely and sometimes almost entirely by foreign
borrowing. Such countries generally do not have
domestic capital markets sufficient to fund government deficits, so reflection in the external deficit is
direct and systematic over time.
Even the developed economies, however, cannot
rely on domestically generated savings to finance
budget deficits above a certain size. What has not
held systematically for them can certainly hold
episodically, with threshold effects, when govern9
Table 2
RELATIONSHIP OF EXTERNAL BALANCE
AND FISCAL BALANCE ACROSS COUNTRIES
(M - X) = IX + {3(G - T)
Area
Interval
Constant
Fiscal
balance
coefficient
/i. 2
DW
Rho
Industrial countries
United States
1948-82
-5.54
(-3.47)
-.12
(-3.01)
.43
1.48
.35
Japan
1955-79
-194.62
(-.62)
-.10
(-1.53)
.12
1.42
.20
Germany. ..........
1950-82
-10.64
(-2.64)
-.31
(-1.51)
.47
1.37
.57
United Kingdom.
1948-82
-.48
(-.62)
-.24
(-1.93)
.67
1.45
.75
Canada.
1948-82
.96
(2.65)
.17
(2.58)*
.14
1.56
France.
1950-81
-1.10
(-.28)
.08
(.34)
.14
1.27
.32
Italy.
1951-82
-148.68
(-.19)
.22
(6.39)*
.72
1.69
.32
Switzerland.
1948-82
-2.56
(-3.20)
-.73
(-1.51)
.59
.93
.57
Netherlands
1950-82
-.49
(-.40)
-.40
(-3.21)
.52
1.54
.59
Belgium.
1958-82
-15.84
(-1.24)
.20
(3.76)*
.83
1.47
.67
Sweden.
1948-80
-.39
(-.77)
.22
(4.57)*
.38
1.68
Norway.
1954-76
-.87
(-1.21 )
1.96
(10.34)*
.91
1.73
.55
Finland
1948-81
.39
(.64)
.63
(2.12)
.36
1.30
.57
Australia.
1949-82
2.61
(1.32)
-.57
(-2.35)
.68
1.75
.93
New Zealand
1950-81
18.02
(.31)
.67
(6.77)*
.59
1.84
Austria.
1948-81
-1.20
(-1.07)
.49
(6.69)*
.57
1.98
Spain.
1962-82
83.62
(2.07)
.40
(4.60)*
.67
1.47
Ireland.
1948-82
-5.77
(-.25)
.94
(23.90)*
.94
1.62
.34
Continued on next page
10
Federal Reserve Bank of Dallas
Table 2-Continued
Area
Interval
Constant
Fiscal
balance
coefficient
"R2
DW
Rho
Industrial countries- Continued
1948-81
379.23
(.91)
1.46
(.85)
.55
.48
.91
Brazil.
1950-81
44.26
(1.35)
-70.81
(-6.56)
.72
1.30
.34
India
1950-79
-.36
(-.11)
.18
(1.29)
.02
2.02
Mexico . . . . . . . . . . .
1966-80
-4.68
(-.68)
1.14
(11.26)*
.96
1.55
.58
Turkey.
1967-80
.56
(.08)
.82
(8.81)*
.85
2.00
-.12
Argentina
1967-79
-3.64
(-.51)
.39
2.65
-.45
Yugoslavia
1960-81
14.76
(1.41)
3.33
(2.93)*
.59
.96
.32
South Africa .
1948-82
-109.95
(-.27)
.69
(1.81)
.21
1.55
.45
Indonesia
1969-82
-174.61
(-.37)
1.42
(1.79)
.19
1.46
.20
Nigeria.
1965-78
118.52
(.33)
.16
(.52)
-.05
1.59
.10
Hungary . . . . . . . . . .
1970-82
22.42
(1.78)
-1.62
(-.74)
.09
1.81
.32
Greece.
1951-82
11.47
(2.81)
.72
(8.06)*
.67
2.03
Philippines
1957-80
2.51
(2.25)
1.47
(3.80)*
.76
1.06
Thailand
1950-82
1.45
(.72)
1.32
(6.96)*
.60
1.64
Israel.
1957-80
340.49
(1.50)
1.20
(22.62)*
.96
1.72
Pakistan
1960-81
1.42
(1.96)
.30
(3.51)*
.52
1.68
.28
Malaysia.
1960-82
-1,020.98
(-1.41)
.71
(4.71 )*
.69
1.31
.62
Morocco.
1965-80
-.90
(-3.20)
1.00
(14.00)*
.93
1.55
Singapore
1963-81
874.60
(4.40)
-3.69
(-3.89)
.44
1.45
Iceland
Developing countries
-.24
(-3.78)
.59
Continued on next page
Economic ReviewlJanuary 1984
11
Table 2-Continued
Area
Interval
Constant
Fiscal
balance
coefficient
/;:2
DW
Rho
Developing countries- Continued
Ecuador.
1950-81
1.79
(2.12)
1.21
(5.90)*
.70
1.81
.35
Sudan
1967-79
7.10
(.37)
1.44
(5.98)*
.75
1.89
.02
Guatemala
1958-81
71.20
(2.48)
.88
(5.68)*
.69
2.06
.33
Burma.
1948-79
202.27
(1.01)
.54
1.86
.73
Zaire
1966-81
-148.90
(-.99)
2.29
(6.64)*
.74
1.72
Kenya
1964-81
146.84
(.22)
2.09
(4.07)*
.48
2.17
Ethiopia.
1964-78
28.51
(.87)
.68
(3.39)*
.43
1.96
Sri Lanka.
1950-82
-589.74
(-1.17)
1.16
(19.26)*
.98
1.37
.74
Tanzania
1968-79
157.69
(.38)
1.25
(4.79)*
.67
1.97
.01
Bolivia.
1959-82
3,483.27
(2.23)
-.10
(-2.52)
.34
1.90
.13
Panama.
1948-80
20.00
(3.11)
1.00
(15.45)*
.94
1.74
.38
Jamaica.
1960-80
117.36
(3.18)
-.13
(-1.18)
.02
2.12
Zambia
1964-79
-133.02
(-2.49)
.34
(1.06)
.01
2.13
EI Salvador.
1954-82
75.98
(2.14)
1.06
(5.24)*
.49
1.67
Nicaragua ..
1960-79
106.69
(.26)
-.00
(-.00)
.17
1.04
.59
Jordan.
1959-82
52.30
(2.20)
2.07
(4.92)*
.72
1.61
.32
Honduras
1950-82
110.67
(2.64)
.72
.78
.91
.62
(2.42)
-.38
(-2.13)
Cyprus.
1966-81
13.02
(2.47)
1.66
(8.24)*
.82
1.64
Haiti.
1967-82
120.47
(2.49)
2.23
(8.54)*
.83
2.52
Continued on next page
12
Federal Reserve Bank of Dallas
Table 2-Continued
Area
Interval
Constant
Fiscal
balance
coefficient
li2
DW
Rho
.46
Developing countries- Continued
Liberia.
1965-81
42.06
(2.53)
.44
(1.70)
.51
1.75
Malawi
1964-82
15.93
(1.47)
1.70
(6.92)*
.72
1.48
Sierra Leone
1964-81
1.42
(.11)
1.62
(9.24)*
.95
1.79
.66
NOTE: Figures in parentheses are t statistics; • indicates significance of the independent variable at the 99-percent
level, using a one-tailed test that the variable is signed as hypothesized.
Ii 2 is the coefficient of determination adjusted for degrees of freedom.
DW is the Durbin-Watson autocorrelation test statistic. A generalized least-squares procedure was used to
correct for first-order autocorrelation in cases where the ordinary least-squares Durbin-Watson statistic was
not acceptable.
Rho is the first-order autocorrelation coefficient and is reported only in cases where the generalized leastsquares procedure was employed.
In each case, the fiscal balance is that of the central government. The external balance includes net factor
payments to and from abroad but does not include net transfer payments. All data were in units of local
currency, so the constant term cannot be compared across countries
SOURCE OF PRIMARY DATA: International Monetary Fund (International Financial Statistics).
ment deficits become large relative to the savings
pool and the overall economy.
The United States now sees the effects of its
fiscal deficit on the external side. The unified
federal deficit as a percentage of gross national
product has recently risen markedly (Chart 3). Under
these conditions, discounting the possibility of a major increase in the private domestic savings rate, the
United States can expect a continued reflection of
the budget deficit in the current account deficit.
Returning to the national accounts framework for
illustration, both a country's external balance and
its private sector balance can be driven causally by
the government balance:
(7)
(M -
X)
+
(5 -
I)
~
(G -
T).
Rising domestic interest rates, then, not only appreciate the currency and contribute to a current
account deficit but also discourage investment
relative to savings sufficiently that both foreign and
domestic contributions are necessary to finance the
government sector. The crowding-out effects of the
budget deficit operate on private domestic investment as well as on exports and import-competing inEconomic ReviewlJanuary 1984
dustries. (Should the current account deficit make
its influence on the dollar felt, currency depreciation cou Id correct the external imbalance. A continued budget deficit would then be felt mainly in
the domestic economy.)
Concluding comments
The solution to dollar overvaluation suggested by
this article is to continue allowing the market to set
the exchange rate but to foster underlying conditions that enable the market to set a more appropriate rate. Ultimately, this can only mean reducing
the federal deficit.
If the budget deficit goes on being reflected in a
growing current account deficit, the capital inflows
necessary to finance the latter at a constant exchange rate must also grow. Will the increased inflows be forthcoming from a world skeptical of the
haven currency country's ability or determination to
put its own house in order? Budget deficit reduction
is a well-recognized, if still rather controversial, subject in the United States. But there is probably insufficient recognition of the international scope. The
dollar could drop precipitously if potential foreign
13
Chart 3
Unified U.s. Budget Deficit Relative to Nominal GNP
PERCENT OF NOMINAL GNP
6 r---------------------------------------------------------------------~
-4
~1
________
1948
SOURCE:
u.s
~I
1953
______ ________
~I
1958
~I
1963
~i
1968
~I
1973
______ ________
~I
1978
~1
1983
Department of Commerce, Bureau of Economic Analysis
inflows turn into outflows. And such outflows would
at the same time exacerbate, rather than help
alleviate, a domestic shortage of funds.
Finally, the fiscal approach to the balance of
payments taken in this article can easily be turned
into a monetary approach. The developing-country
case is again a useful analogy, because insufficient
domestic sources of funds put added pressure on
the central bank to monetize the deficit. Fiscal
14
______ ________
deficits drive monetary expansion, inflation explodes, nominal interest rates rise while real
rates drop, and the currency depreciates. In the
advanced-country case, where lower deficits might
be financed in domestic capital markets without
monetization, add a complaisant central bank to a
deficit out of control and that country moves
toward the developing-country scenario.
Federal Reserve Bank of Dallas
How Fiscal Policy Matters
By John Bryant*
In the fiscal policy of the United States, emphasis
has been shifted from social programs to defense
and from tax financing to deficit financing. National
defense outlays, which were 23.2 percent of total
Federal Government outlays in 1980, were estimated
to rise to 27.8 percent of the total in the 1984 budget, according to the 1984 Economic Report of the
President. Deficits, which have risen even more
dramatically, were 10.3 percent of outlays in 1980
and were estimated to become 21.5 percent in the
1984 budget.
Do these shifts matter from a macroeconomic
perspective? I n other words, how do they affect ou r
economy's aggregate production and consumption
of goods and services? Of particular concern, the
subject of heated debate inside and outside the Ad-
* John Bryant is the Fox Associate Professor of
Economics at Rice University and is a consultant
at the Federal Reserve Bank of Dallas. The
views expressed are those of the author and do·
not necessarily reflect the positions of the
Federal Reserve Bank of Dallas or the Federal
Reserve System.
Economic ReviewlJanuary 1984
ministration, is how the huge and growing deficits
will affect private investment.
Of course, such issues are not just of interest now
but will be important questions for policymakers
into the foreseeable future. This article does not address the magnitude of the various effects of fiscal
policy. Rather, it discusses the avenues through
which fiscal policy influences the private sector and
describes qualitatively the effects of fiscal policy.
The macroeconomic effects of fiscal policy are
certainly not a new issue. In his 1821 book Principles of Political Economy and Taxation, David
Ricardo presents an analysis implying that deficit
finance is not important from a macroeconomic
perspective. Ricardo goes on to suggest why this
analysis does not apply in reality-why this "government irrelevance" result does not hold.'
1. For discussions see, for example, Kevin D. Hoover and Joseph
R. Bisignano, "Classical Reflections on the Deficit," Weekly
Letter, Federal Reserve Bank of San Francisco, 14 October
1983, and Gerald P. O'Driscoll, Jr., "The Ricardian Nonequivalence Theorem," Journal of Political Economy 85
(February 1977): 207-10.
15
Although It seems intuitively obvious to the
modern observer that the government budget is of
particular importance for the economy, it is,
nonetheless, instructive to follow in Ricardo's
footsteps and examine the various avenues of influence of fiscal policy. Indeed, in the economics
literature there has of late been a resurgence of interest in the Ricardian proposition and in broadening Ricardo's analysis. 2 This resurgence of interest is
at least partly due to the increased urgency of the
issues involved. The basic thrust of the recent work
is to examine precisely in what respects the government is a special economic agent.
The important distinguishing characteristic of the
government is that it can raise revenue through
taxes, whereas businesses must ultimately rely on
sales. The government is not subject to the
discipline of the marketplace. Consequently, the
government redistributes income and produces and
uses goods and services without considering the
profitabil ity of these actions and without the consent of some of the interested parties. This explains
why more attention is focused on the fiscal pol icy
of the government than on the activities of, for
example, Exxon.
It follows that fiscal policy is important because
(1) taxes and transfer payments are costly to administer, (2) taxes and transfer payments reduce
incentives for production in the private sector, (3)
government redirects expenditures in ways that affect aggregate welfare or efficiency, and (4) private
citizens may underestimate, or ignore, the future tax
liability of paying off government bonds. These
avenues of influence of fiscal policy are illustrated
below. For the most part, the analysis implies that
"expansive" government fiscal policy actually
reduces production and investment. Moreover, this
2. Recent literature considers the "irrelevance" not only of bond
versus tax financing but also of government expenditures.
Some elements of this analysis can be found in Robert J.
Barro, "On the Determination of the Public Debt," Journal of
Political Economy 87 (October 1979, pt. 1): 940-71; John
Bryant, "Government Irrelevance Results: A Simple
Exposition," American Economic Review 73 (September 1983):
758-61; Joseph E. Stiglitz, "On the Relevance or Irrelevance of
Public Financial Policy," NBER Working Paper Series, no. 1057
(Cambridge, Mass.: National Bureau of Economic Research,
January 1983); and Neil Wallace, "A Modigliani-Miller
Theorem for Open-Market Operations," American Economic
Review 71 (June 1981): 267-74.
16
Figure 1
Simple Production
x
X*
INDIFFERENCE
CURVES
L-________
~
__________
Y*
~
_____________ Cy
a
ex is consumption of good x, and C v is consumption of good y Feasible
consumption bundles are represented by the straight line running from X on
the C axis to a=(1 +r)X on the Cy axis. The individual chooses the fea"ble
consumption bundle that is on the highest indifference curve, namely,
(,=X' and Cy=Y' The optimal consumption of good x is X', and the
remainder of the endowment of good x, (X - X'), IS used to produce
Y' =(1 + r) (X - X') units of good y
reduction is effected without an increase in interest
rates.
How costly administration
of taxes and transfers matters
A simple model is useful to illustrate the avenue
whereby taxes and transfer payments likely reduce
production. For simplicity, assume an economy with
fully employed resources and no money.3 Suppose
the economy consists of identical individuals. Then,
an analysis of the effect of government pol icy on
one individual leads to conclusions that can be extended to the economy as a whole. Assume there
are just two goods, x and y, to permit the use of
graphical analysis. Further assume each individual is
endowed with X units of good x and no units of
3. A more general treatment appears in John Bryant, "Banking,
Recession, Depression, and Government Expenditure," Journal
of Banking and Finance 6 (December 1982): 549-59.
Federal Reserve Bank of Dallas
Figure 2
Figure 3
Transfer Payments
with Administrative Costs
Taxes and Incentives
ex
ex
X+G
X
x
X-(T-G)
L-----~--~~----~----~----------ey
~------~--~----~----~~------ey
y2
Costly government transfer
of good x by (T - C). Feasible
the straight line running from
normal goods, this causes the
from V' to V'
Y*
b
a
payments effectively reduce the endowment
consumption bundles are now represented by
X - (T - C) on the C, axis. If the goods are
individual to reduce production of good y
good y. However, the available technology enables
each individual to transform good x into good y at
the rate 1 to (1 +r), From holdings of good x, the individual chooses the amount of good y to produce
that maximizes her welfare. The solution to this
problem is illustrated in Figure 1. In general, the
individual chooses to consume some of each good.
Now add government taxes and transfer payments
to the example. It is a standard assumption in
macroeconomics that the effects of such redistributions cancel out in the aggregate. For example, the
recipient of a transfer payment increases saving by
the amount that the taxed individual reduces saving.
A simple way to build this feature into a model is to
assume taxes and transfer payments accrue to the
same individual.
Suppose the government taxes the individual T
units of good x and makes a "transfer payment" to
the individual of G units of good x. If this activity
consumes no resources, it obviously has no effect
on the individual, as G equals T. Otherwise, the in-
Economic Review/January 1984
Y*
b
a
A tax on production and a cost less government transfer payment do not
affect the set of technologically feasible consumption bundles, which is
still represented by the straight line running from X on the C, axis to
a=(1 + r)X on the Cy axis. However, the individual's perceived budget set is
now represented by the straight line running from (X + C) on the C, axis to
b=[(1 + r)/CI +t)] (X+C) on the Cy axis. The perceived budget set must
induce the indiVidual to choose a technologically feasible consumption
bundle. Therefore, to balance the government budget, t must be set so that
the consumption bundle in the budget set that is on the highest indifference curve is also feasible, as illustrated. This causes the individual to
reduce production of good y from V' to VI.
dividual gets a transfer payment less than her tax,
so G is less than T. Effectively, the individual's endowment of x has been reduced by (T - G), the
cost of administering the program. If x and yare
normal goods, this waste reduces production. This
point is illustrated in Figure 2.
As a "real world" example, social security
redistributes income from workers to retired people,
but the program is costly to administer. The program may be viewed as taking money from a person
and then giving it back to her in two respects. First,
money taken from her in her working years is
returned to her when she retires. Alternatively, many
working-age people would, in the absence of social
security, contribute more to the support of their
parents. Social security thus takes money from one
pocket and returns it to another. More generally,
the effects of redistributing income from workers to
17
Figure 4
Figure 5
Excessive Government Production
Private Production
with Excessive
Government Production
Cx
x
X-T
X-T
L-----------~----~~--~~---------Cy
y*
y4
Excessive government production of good y, y4=(1 + r)T, effectively
reduces the endowment of good x by T and effectively gives the individual
an endowment of good y of y4 Because the individual would lik" to
"unproduce" some of good y but cannot do so, she consumes C
(X - T)
and Cy =y4 and is worse off.
=
L-______- L__L-__
~~
____
~
__________
Cy
yb ys
I, is the optimal amount of good x allocated to the production of good
z, and yo is the optimal production of good y. If the government uses
(T>I,) units of good x to produce good z, one effect is to reduce the effective endowment of good x. Typically, another effect is a shift in the indifference curves in the (C" C y ) plane as well. If the indifference curves do
not shift "too much" and if the goods are normal goods, production of
good y will fall from yo to yb
retired people may cancel out in the aggregate. But
the goods and services that could have been produced with resources used up by social security
administration are lost to the economy.
How taxes and transfers reduce incentives
I n addition to being costly to administer, taxes and
transfer payments also reduce incentives in the
private sector and thereby reduce production. This
can be illustrated by modifying the above example,
in which taxes were simply levied on a "lump sum"
basis. I n that case, taxes have no effect on incentives; they only reduce income. But consider the
case of a tax based on production.
Suppose the government operates costlessly.
However, the government charges a flat-rate tax on
the input of good x to the production of good y (or,
equivalently, the government taxes the production
of good y). This tax finances the transfer payment
of G units of good x. If the amount of good x
allocated to the production of good y by the individual is I and the tax rate is t, then t must be
chosen so that the resu Iting input satisfies (t I = G).
18
This implies that for the individual the effective rate
of return of production is not (1 + r) but (1 + r)/(1 + t)
< (1 + r). The tax reduces the incentive to produce.
This, in turn, implies that the individual reduces production and is worse off (Figure 3). As a real world
example, the income tax discourages work and
encourages leisure.
Excessive government expenditures
The discussion to this point has covered transfer
payments only. Governments also engage in production, however. If the publicly produced goods can
be substituted for privately produced goods, increases in government production will be matched
by decreases in private production, and the additional government spending will have no macroeconomic effects. But this condition does not
always hold.
For example, government may produce more of a
Federal Reserve Bank of Dallas
Figure 6
Figure 7
Bond-Financed Transfer Payments
Bonds as Spurious Wealth
ex
ex
X+G
~-----L----------~----------~----
-T
0
Y*
a
____ ey
A government transfer payment financed by a bond issue that is, In turn,
retired by taxes effectively increases the endowment of good x by amount
C and effectively gives the individual a "negative endowment" of good y
of - T = - (1 + r)C. However, by using the transfer payment to purchase
bonds in amount C, the individual returns to her original endowment of X
units of good x and no units of good y. Then the individual produces Y'
units of good y, as before.
good than the private sector would in the absence
of government intervention, I n this sense, government production may be termed "excessive," This
may occur because the government is not subject to
the discipline of the marketplace. The government
is not constrained to engage in profitable levels of
activity.
In the first example, suppose the government
taxes the individual T units of good x, uses that
amount of good x as input to produce good y, and
then makes a "transfer payment" to the individual
of C units of good y, If the government operates
costlessly, then C equals (1 + r)T. As long as T is less
than the input the individual would have made
without government interference, this fiscal pol icy
has no significance. The individual simply reduces
her input by the amount T and her production by
the amount (1 + r)T, and total input and production
are unchanged. The government production perfectly "crowds out" private production because the
government is just acting as the individual's producEconomic Review/January 1984
L-______
~
y7
__- L____________
Y*
~
a
""
""
"
______"~____
ey
b
A bond issue and a cost less government transfer do not affect the set of
feasible consumption bundles, which is still represented by the straight line
running from X on the C, axis to a = (1 + r)X on the Cy axis. However, if the
individual ignores the tax liability of the bonds, she will think her endowment of good x increases by C but will ignore her effective "negative
endowment" of good yof -'T= -(1 + r)C. Therefore, the individual's perceived budget set is represented by the straight line running from (X + C) on
the C axis. The individual, overestimating her endowment, increases consumption of good x, if the goods are normal goods, and thus reduces her
production of good y to y7
tion agent. However, if T exceeds the amount of input the individual would choose, total input rises to
T, total production rises to (1 + r)T, and the individual is worse off, as is illustrated in Figure 4.
As a real world example, the Tennessee Valley
Authority (TVA) builds and operates dams that the
private sector could build and operate, If the TVA
dams would otherwise be built and operated by the
private sector, the allocation of resources and total
production in the economy are not affected by the
TVA, Suppose, however, that the dams built by the
TVA are larger or more numerous than the private
sector could profitably build and operate, The
added production of dams cannot be offset by
reductions in private sector dam building. All the
dams in the area are TVA dams already,
As it stands, the two-good example does not allow
illustration of the effect that is exerted by excessive
government production on the private production of
19
other goods. Suppose, however, that there is a third
good in the example and it, like good y, is produced
from good x. Moreover, suppose it is this third good,
z, that the government is overproducing. Let the
welfare-maximizing input of good x into the production of good z be Iz' I z < T. If the amount of good z
consumed does not influence the tastes for goods x
and y4 and if x and yare normal goods, then government overproduction of good z reduces the production of good y (Figure 5).
There may be goods that should be produced but
which the private sector cannot produce-at least
not efficiently. A common example is national
defense. I n such a case, the above analysis of excessive government production still applies, only the
adjective "excessive" has to be deleted, and this
government production need not make the individual worse off. It does, however, likely reduce
private sector production. 5
How bond financing matters
To discuss the final avenue of influence of fiscal
policy, it is necessary to introduce government borrowing into the analysis. Governments generally borrow by selling bonds in one period and collecting
taxes in a subsequent period to repay the bondholders. If in this situation individuals underestimate
their future tax liability, they likely increase consumption today and reduce investment as the bonds
are erroneously substituted for investment. Under
this condition, bond-financed deficits do reduce
private investment. This can be illustrated with a
reinterpretati()n of the above two-good examples.
Suppose each individual lives two periods and
there is one good in each period - good x in Period
1 and good y in Period 2. Under this interpretation, r
is the real interest rate and production of good y is
investment. Suppose the government sells bonds to
4. The individual's utility function is separable in good z.
5. However, some forms of government expenditures-roads, for
example-may affect private production technologies and
thereby may encourage production.
20
the individual in Period 1 for good x in the amount
B and makes a "transfer payment" to the individual
of C units of good x. I n the second period the
government taxes the individual T units of good y
and pays the individual (1 + i)B units of good y to
redeem the bonds.
Consider first the case where the individual keeps
in mind the future tax liability implied by bond
issuance. If the government operates costlessly, C
equals Band (1 + i)B equals T. As the bonds must
compete with production of good y-that is, investment-(1 + i) equals (1 + r). The real interest rate is
not influenced by the bond issue. Moreover, the
individual's investment is not influenced by the
transfer payment and bond issue because the bonds
are held to cover the tax liability T. Saving rises in
the amount of the bond issue. This is illustrated in
Figure 6. (Notice that Figure 6 is essentially identical
to Figure 1.)
Suppose, however, that the individual ignores her
tax liability T. By failing to incorporate the tax
liability into her decision, she overestimates her
wealth. If x and yare normal goods, she reduces her
investment in Period 1 and is ultimately worse off,
as is illustrated in Figure 7. Bonds are erroneously
substituted for investment. As bonds still compete
with production of good y, interest rates are not affected, (1 + i) = (1 + r). However, the realized rate of
substitution of future goods for current goods now
exceeds the rate of interest.
Concluding comments
The preceding analysis has several implications for
the shift in U.S. fiscal policy. The reduced rate of
growth in transfer payments should stimulate production. Increa'sed defense expenditures could lead
to lower private production and investment. Increased government borrowing could stimulate consumption and discourage investment in the near
term but eventually might lead to disappointment
and lower consumption. Lastly, a reduction in investment caused by defense expenditures or by borrowing does not require a rise in interest rates.
Federal Reserve Bank of Dallas
The Economic Review is published by the Federal Reserve Bank of Dallas and
will be issued six times in 1984 (january, March, May, July, September, and
November). This publication is sent to the mailing list without charge, and additional copies of most issues are available from the Publications Department,
Federal Reserve Bank of Dallas, Station K, Dallas, Texas 75222. Articles may be
reprinted on the condition that the source is credited.
@FedFRASER