The sustainability of domestic budget deficits in open economies

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Virginia Polytechnic Institute and State University


This paper presents a framework for exploring the sustainability of U.S. domestic budget deficits in the presence of the currently experienced capital inflows. A 'sustainable' deficit-financing policy is defined as one in which the combination of debt-financing and seigniorage precludes the creation of a large unanticipated inflation to wipe out the debt in real terms. The model implemented is a rational expectations model of the open economy and two separate cases are analyzed.

In Case I, domestic money creation is held 'fixed' and any increases in the deficit are financed by the sale of one-year discounted government bonds to domestic and foreign residents. In Case II domestic money and bonds are both endogenously determined. The asset market, in both the cases, is characterized by perfect capital mobility as defined by uncovered nominal interest parity. Real interest parity, however, does not exist as domestic and foreign goods are not perfect substitutes.

In Case I, the solution of the domestic price level exhibits price-neutrality with respect to the deficits. The nominal and real exchange rates, however, are found to appreciate with increases in deficits and the situation is aggravated further by an exodus of domestic real wealth.

In Case II, on the other hand, deficits are found to be inflationary and both nominal and real exchange rates depreciate with increases in the deficit. Furthermore, increases in the amount of debt being rolled over cause even greater upward pressures on domestic inflation and result in the further weakening of the dollar. The solutions also provide us with an expression for the maximum amount of debt that can be rolled over without causing the domestic price level to explode or the currency to collapse. This 'critical value' of debt is found to bear an inverse relationship to the rate of growth of the domestic deficit. Bond-financed deficits are therefore non-sustainable in both the cases discussed, and the arithmetic, it seems, is unpleasant indeed.