Deficits, Public Debt Dynamics, and Tax and Spending Multipliers

31 Pages Posted: 25 Feb 2012

See all articles by Matthew Denes

Matthew Denes

Carnegie Mellon University - Tepper School of Business

Gauti B. Eggertsson

Federal Reserve Bank of New York

Sonia Gilbukh

City University of New York - Department of Real Estate

Multiple version iconThere are 2 versions of this paper

Date Written: February 1, 2012

Abstract

Cutting government spending on goods and services increases the budget deficit if the nominal interest rate is close to zero. This is the message of a simple but standard New Keynesian DSGE model calibrated with Bayesian methods. The cut in spending reduces output and thus — holding rates for labor and sales taxes constant — reduces revenues by even more than what is saved by the spending cut. Similarly, increasing sales taxes can increase the budget deficit rather than reduce it. Both results suggest limitations of “austerity measures” in low interest rate economies to cut budget deficits. Running budget deficits can by itself be either expansionary or contractionary for output, depending on how deficits interact with expectations about the long run in the model. If deficits trigger expectations of i) lower long-run government spending, ii) higher long-run sales taxes, or iii) higher future inflation, they are expansionary. If deficits trigger expectations of higher long-run labor taxes or lower long-run productivity, they are contractionary.

Keywords: fiscal policy, liquidity trap

JEL Classification: E52, E62

Suggested Citation

Denes, Matthew and Eggertsson, Gauti B. and Gilbukh, Sonia, Deficits, Public Debt Dynamics, and Tax and Spending Multipliers (February 1, 2012). FRB of New York Staff Report No. 551. Available at SSRN: https://ssrn.com/abstract=2010640 or http://dx.doi.org/10.2139/ssrn.2010640

Matthew Denes

Carnegie Mellon University - Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

HOME PAGE: http://sites.google.com/site/matthewdenes

Gauti B. Eggertsson (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Sonia Gilbukh

City University of New York - Department of Real Estate ( email )

United States

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