[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

ing a large tax cut through Congress in 2001. The September 11, 2001, terrorist
attacks on the United States led to substantial increases in military expenditures.
And the expiration in 2002 of the “pay-as-you-go” rule introduced in the 1990s
removed a significant restraint on government spending.
But if we focus just on the current deficit, we will miss the big picture as far as
the federal budget is concerned. Because of the aging of the American population,
health care (Medicare and Medicaid) and Social Security payments are expected
to grow significantly as a fraction of GDP. If huge deficits are to
be avoided, either the generous benefits of current programs
will have to be reduced or large tax increases will be necessary.
But should we care about these deficit forecasts? Does it
matter whether the government pays for its expenditures by
raising enough tax revenue or instead simply borrows? Despite
r 1
the big increase in the deficit, some commentators have claimed
that deficits are unimportant to the overall health of the economy.
To understand their arguments, it will be helpful to briefly r 0
review the traditional view on the impact of deficits.
DEFICITS AND THE
TRADITIONAL VIEW
In Chapter 25, the full-employment model was expanded to
include government spending and taxing. We learned that a government
deficit reduces national saving. When the government
runs a deficit, spending more than it receives in revenue, it must
borrow in the capital market, thereby reducing the amount of
saving available for private investment. Figure 38.2A depicts the
effect of a fiscal deficit on the capital market in a closed economy.
The deficit increases the equilibrium real interest rate, and
reduces the equilibrium level of private investment spending by
crowding out private investment spending. Over time, lower
levels of investment reduce incomes as the economy accumulates
less capital. Thus, the analysis of Chapter 25 concluded
that deficits do matter.
Reducing the deficit or actually running a surplus has the
opposite effect (see Figure 38.2B). It enables the real interest
rate to fall, stimulating private investment and thus promoting
economic growth and better future living standards.
But is this always the case? Do deficits always reduce future
income? We saw in Chapter 26 that in one case—the small open
economy—deficits do not affect the interest rate or investment.
For such an economy, the supply curve of saving is horizontal,
at the interest rate set by the global world capital market. A
fiscal deficit results in borrowing from abroad—a capital inflow—
without changing the interest rate. Private investment is not
crowded out, as would be the case in a closed economy. Instead,
REAL INTEREST RATE (r )
REAL INTEREST RATE (r )
r 1
r 0
Figure 38.2
National
savings
Private
savings
Fiscal
deficit
A
Fiscal
surplus
Private
savings
SAVING (S) AND INVESTMENT (I )
National
savings
SAVING (S) AND INVESTMENT (I )
B
Investment
schedule
Investment
schedule
THE GOVERNMENT BUDGET AND THE CAPITAL
MARKET IN A CLOSED ECONOMY
A budget deficit reduces national savings, leading to a higher
equilibrium real interest rate and lower investment, as depicted
in panel A. A surplus has the opposite effect, as illustrated in
panel B.
DO DEFICITS MATTER? ∂ 839