Macroeconomics Fiscal Deficit and Trade Balance

Topics: Monetary policy, Macroeconomics, Inflation Pages: 17 (5551 words) Published: December 14, 2011

Fiscal Deficit is an economic phenomenon, where the Government's total expenditure surpasses the revenue generated. It is the difference between the government's total receipts (excluding borrowing) and total expenditure. Fiscal deficit gives the signal to the government about the total borrowing requirements from all sources. Fiscal Deficit has received much of the blame for the assorted economic ills that beset developing countries in the 1980s and ‘90s rather today also: overindebtedness and the debt crisis, high inflation, and poor investment performance and growth. We need to analyze the fact whether only fiscal should be blamed for the macroeconomic imbalances in an economy. Different views advocate different effects as under:

- Neoclassical View contests that Fiscal deficits are detrimental. Revenue deficit in fiscal deficits implies a reduction in government saving. This will have a detrimental effect on growth if the reduction in government saving is not fully offset by a rise in private saving, thereby resulting in a fall in the overall saving rate. Model Assumes full employment situation. In this paradigm, fiscal deficits raise lifetime consumption by shifting taxes to the future generations. - Keynesian View sees Fiscal deficits as beneficial. Envisages that an increase in autonomous government expenditure, whether investment or consumption, financed by borrowing would cause output to expand through a multiplier process. - Ricardian Equivalence Perspective views fiscal deficit as neutral in terms of their impact on growth. The financing of budgets deficits amounts only to the postponement of taxes. The model assumes that individuals in the economy are foresighted and they believe that any reduction in the taxes in the current period will lead to higher taxes in the future and in turn starts saving more and consuming less.

In reality, an economy may be populated by all the three types of consumers. Depending on which group is relatively larger, one or the other theory may be found to be more relevant in different contexts.

One recurring question is whether larger public deficits are always associated with higher inflation. Sargent and Wallace's (1985) "monetarist arithmetic" answered this question affirmatively. But the relationship is blurred because governments finance deficits by borrowing as well as by printing money. The relationship is further muddied by other influences such as unstable money demand, inflationary exchange rate depreciations, widespread indexation, and stubborn inflationary expectations. And if larger public deficits are associated with higher inflation, what are the tradeoffs in financing the deficit through money creation? Interest rates are another ambiguous factor. Do deficits push up domestic real interest rates when governments rely heavily on domestic debt instruments, or are this relationship also blurred by such factors as interest rate or credit allocation controls or the high degree of substitutability between public debt instruments and other assets held by the private sector? Will consumers reduce their spending when taxes are raised and increase it when taxes are lowered? Or will they offset only changes in government consumption-without reacting to changes in government tax or debt financing as posited by Ricardo and, by Barro. Although there is growing evidence that refutes Barro's Ricardian equivalence proposition for developing countries. Another unresolved issue concerns the effects of government spending on investment. Does a higher level of public capital spending boost (crowd in) or lower (crowd out) private investment? Theory predicts, and the limited evidence available for developing countries confirms, that the effect depends on whether private and public investment complement or substitute for each other. If real interest rates do rise in response to higher domestic debt financing of deficits, how does that affect private...
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