Budget Deficits and Rates of Interest in the World Economy

36 Pages Posted: 27 Apr 2000 Last revised: 15 Sep 2010

See all articles by Jacob A. Frenkel

Jacob A. Frenkel

Merrill Lynch & Co. - Sovereign Advisory Group and Global Financial Institutions Group; National Bureau of Economic Research (NBER)

Assaf Razin

Tel Aviv University - Eitan Berglas School of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Date Written: May 1984

Abstract

This paper deals with the international transmission of the effects of budget deficits on world rates of interest and spending. The model assumes a two-country world within which capital markets are integrated, individuals behave rationally, and the behavior of individuals and governments are governed by temporal and intertemporal budget constraints. Adopting Olivier Blanchard's formulation it is assumed that due to the probability of finite life individuals behave as if their horizon was finite. This formulation generates asimple pattern of aggregate behavior of the two-country world, and it assures that the model is not subject to the Ricardian proposition according to which budget deficits do not matter. It is shown that, for a given time path of government spending, a budget deficit raises world rates of interest and domestic wealth while it lowers foreign wealth. Thus, the deficit is transmitted negatively to the rest of the world. The channel of transmission is the world capital market and the negative transmission results from the higher rate of interest. The paper proceeds with an analysis of balanced-budget changes in government spending. It is shown that a transitory current rise in government spending raises interest rates and lowers domestic and foreign wealth while an expected future rise in government spending lowers interest rates, reduces the value of domestic wealth and raises the value of foreign wealth. The effect of a permanent rise in government spending on the rate of interest depends on whether the domestic economy is a net saver or dissaver in the world economy, i.e., if it has acurrent account surplus or deficit. If the home country runs a current account surplus then a rise in government spending raises world interest rates and lowers domestic and foreign wealth, and if the home country runs a current account deficit then a permanent balanced-budget rise in government spending lowers interest rates and domestic wealth and raises foreign wealth.

Suggested Citation

Frenkel, Jacob A. and Razin, Assaf, Budget Deficits and Rates of Interest in the World Economy (May 1984). NBER Working Paper No. w1354. Available at SSRN: https://ssrn.com/abstract=227156

Jacob A. Frenkel

Merrill Lynch & Co. - Sovereign Advisory Group and Global Financial Institutions Group

New York, NY
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Assaf Razin (Contact Author)

Tel Aviv University - Eitan Berglas School of Economics ( email )

P.O. Box 39040
Ramat Aviv, Tel Aviv, 69978
Israel
+972 3 640 7303 (Phone)
+972 3 640 9908 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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