Academic journal article Journal of Economics and Economic Education Research

Effect of Government Deficit Spending on the GDP in the United States

Academic journal article Journal of Economics and Economic Education Research

Effect of Government Deficit Spending on the GDP in the United States

Article excerpt

INTRODUCTION

Deficit spending by a government and how it relates to the economy as measured by the GDP is of fundamental importance in shaping economic policy for a country, especially at a time of economic downturn. It is of importance to determine if deficit spending would have an influence on economic growth. The literature is mixed on this issue. Some economists are of the opinion that deficit spending has a negative effect on the economy in that it increases interest rate which leads to a decrease in investment. Others argue that deficit spending has a positive effect by increasing demand. On the other hand, there are those that argue for no effect on the economy.

If deficit spending has a negative effect on growth, then fiscal austerity would be legitimate as a remedy for an economic downturn. On the other hand, austerity measures would be detrimental to the economy if deficit spending is the right stimulus for growth.

From the arguments above, it is clear that empirical studies to determine the relationship between government spending and economic growth are of utmost importance. In this study, we employ time series analysis techniques to investigate the relationship between federal deficit spending and economic growth in the United States over the time period 1930-2010.

RELEVANT LITERATURE

Kiani (2007) showed that there was a positive effect of budget deficit in the US and long term interest rate. Also, a positive effect of budget deficit on interest rate in the United States was reported by Feldstein (1986) and Holster (1986). Posner (1987), Krueger (2003), and Macao (2003) argued that an increase in interest rate would cause a decrease in investment, which would decrease economic growth. On the other hand, studies by Makin (1983), Plosser (1982), and Evan (1985) showed no evidence of a relationship between budget deficit and interest rate.

Cebula (2008) provided evidence through co-integration analysis and an error correction model, indicating that federal deficit in the US, over the period 1973-1996, and interest rates on high-grade tax-free municipal bonds were positively correlated. An increase in budget deficit is accompanied by an increase in real interest rate. Also, there was some indication that high interest rate has a positive effect on federal deficit. This indicates a bidirectional relationship between the two variables. It is difficult, however, to infer cause and effect from a correlation.

Collins (1999) presented coefficients of correlation (on data between 1944 and 1994 in the US) between deficits and stocks and bonds as well as data on deficits and investment and interest rates. Results were not consistent with the argument that deficits cause an increase in interest rate and a decrease in GDP growth, investment, and stock performance.

Nikannen (1978) reported that budget deficit led to an increase in government spending, but had no effect on inflation over the period 1947-1976 in the United States

Pollin (2012) concluded from his study that the US government deficit related to the 2009 economic stimulus did not cause an increase in interest rate or inflation.

Siklos (1988) using spectral and time series analysis on quarterly (1950- 1984) and annual data (1871- 1984) in Canada found no empirical evidence to show that government spending had an effect on long term interest rate.

Giffin et al (1981) analyzing time series data over the years 1959-1979 in the US, reported that there was no significant correlation between deficit spending and inflation rate.

Ball and Markiw (1995) presented empirical evidence which showed that large deficits over the period 1982 to 1994 was accompanied by a decline in investment, export, and private saving..

Eisner (1989) and Domar (1993) argued that deficit spending can improve the economy at a time of economic slowdown

Hoelscher (1986), using regression analyses on time series data over the period 1953-1984 in the US, reported that deficit caused long term interest rate to rise. …

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