Budget deficits and investment

The existence of a causal relationship between budget deficits and investment requires a transmission mechanism between these two variables. Several authors such as Cebula, Hung and Manage (1995), Cebula and Belton (1992), and Cebula and Scott (1991) point to a positive relationship between budget deficits and interest rates. The existence of a relationship suggests that interest rates are that transmission mechanism.

On the other hand, researchers such as Evans (1985, 1987), and Kormendi (1983) find no relationship between budget deficits and interest rates which suggests the existence of an alternative transmission mechanism between budget deficits and private investment if one truly does exist.

These empirical studies support two opposing views in the relationship between budget deficits and interest rates: the Neoclassical view and the Ricardian Equivalence view.

According to the Neoclassical view, budget deficits crowd out private investment through having a positive relationship with interest rates. Positive budget deficits cause an increase in the demand for loanable funds which leads to an increase in interest rates.

Under the Ricardian Equivalence view there would be no crowding out of private investment when the government borrows money because people will reduce consumption and increase savings in order to offset the increase in future tax liabilities which they foresee as a result of government spending deficits.

Facts, like beauty, can lie in the eye of the beholder. 😉

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