The Effects of Fiscal Policy in a Two-Country World Economy: An Intertemporal Analysis

By Lee, Yeonho | Journal of Money, Credit & Banking, August 1995 | Go to article overview

The Effects of Fiscal Policy in a Two-Country World Economy: An Intertemporal Analysis


Lee, Yeonho, Journal of Money, Credit & Banking


THE REAGAN TAX CUTS of 1981 marked the beginning of an unusual shift in the internal and external imbalances of the United States. The gross federal debt held by the public had grown from $784 billion in 1981 to $2050 billion in 1988. The federal budget had shown persistent deficits, ranging from $128 billion in 1982 to $221 billion in 1986. At the same time, the U.S. economy witnessed the sharp rise in the trade deficit from $28 billion in 1981 to $160 billion in 1987. Between 1981 and early 1985 the trade deficits were accompanied by a real appreciation of the dollar. The concurrence of these events has stimulated continued interest in the effects of budget deficits.

Conventional analysis of fiscal policy attributes the large trade deficits and the real appreciation of the dollar to the dramatic increase in the budget deficit, by presuming that the private sector views public debt as net wealth; see, for example, Dornbusch's (1976) version of the Mundell-Fleming model. Recent research on fiscal policy, revived by Barro (1974), maintains that pure substitution of debt for current taxes has no real effects on the economy. This debt neutrality proposition has called attention to the importance of the structure of government spending and taxes. Evans (1986) finds no evidence that the dollar appreciates because of the large budget deficits. Again, Evans (1988) finds that current account balances in major industrial economies are independent of budget deficits. These findings suggest that changes in tax rates or government spending policies may be critical in understanding the large trade deficits and the strong dollar.

Remarkably, there were frequent tax reforms in the United Stated during the 1980s. The Economic Recovery Tax Act of 1981 reduced the effective tax rate on capital by more than 50 percent compared to the level prevailing in 1980. The Tax Equity and Fiscal Responsibility Act of 1982, the Interest and Dividends Tax Compliance Act of 1983, and the Deficit Reduction Act of 1984 scaled back some of the investment incentives. The Tax Reform Act of 1986 increased the effective marginal tax rate on capital income from 34.5 to 38.4 percent. Another interesting feature of fiscal policies is exhibited by a shift in the structure of government spending. While federal expenditure as a fraction of GNP declined from 24.7 percent in 1982 to 23.7 percent in 1988, the composition of federal spending shifted away from nondefense investment purchases toward defense and consumption purchases (U.S. Council of Economic Advisers 1989).

This paper presents a two-country general equilibrium model of the world economy to analyze the immediate impact and the dynamic and steady-state effects of budget deficits on the trade balance and the terms of trade. The analysis extends the closed-economy framework developed by Judd (1985, 1987) to a two-good, two-country world economy. Each country is populated by an infinitely lived representative agent with perfect foresight. In such a model any real effects of budget deficits arise from the optimal responses of a representative agent to fiscal policy changes, but not from the wealth effects of public debt.

In view of the U.S. experience, the paper considers two different fiscal policies: (1) a temporary cut in the capital income tax that is financed by a future increase in the capital income tax and (2) an increase in government consumption purchases that is financed by a decrease in productive government purchases.(1) Here, government consumption purchases are defined as perfect substitutes for private consumer spending, and productive government purchases as inputs to private production.(2) Aschauer (1985) and Kormendi (1983) report that one unit of government expenditure crowds out private consumer spending by 0.23 to 0.41 unit in the United States. More recently, Aschauer (1989a, b) finds that nonmilitary public capital has significant explanatory power for the productivity of private capital in the United States. …

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