Year: 1983
Type: article
Abstract: If Congress does not act, the U.S. federal budget deficit could easily exceed $200 billion in each of the three fiscal years 1983-85. 1 This budget hemorrhage would come on top of deficits averaging $76.5 billion per year over the last three fiscal years and would make sixteen straight years the budget has been in the red.Deficits have been persistent and have been getting larger.The divergence of the government's expenditures and revenues perhaps has been no larger than the divergence of economists' views on that policy's likely economic effects.And nowhere has the divergence of views seemed wider than on its inflationary effects.Many economists argue that persistently higher deficits do not necessarily lead to higher inflation.(See, for example, Blinder 1982, Friedman 1981a, Grossman 1982, Hamburger and Zwick 1981, Hein 1981, Sprinkel 1981, and Weintraub 1981.)They argue that inflation results when the supply of money grows faster than the supply of goods, which in turn results when the Federal Reserve purchases too many government bonds.These economists (whom I label monetarists) thus conclude that the Federal Reserve can prevent higher deficits from causing more inflation by refusing to buy the extra government bonds that result from those deficits (that is, by refusing to monetize the deficits).As support for this view that higher deficits are not necessarily inflationary, monetarists cite numerous empirical studies which indicate weak, if any, correlation between deficits and inflation in the United States.In this paper, I take the opposing view: Persistently higher deficits-changes in budget policy that for any given economic conditions imply higher deficits than would have occurred under previous budget policy-do indeed lead to more inflation.A theory which admits the possibility of such policy changes suggests that the changes affect inflation in three ways.One way is by necessary monetary accommodation.Contrary to what monetarists believe, the Federal Reserve may have to monetize some of the extra debt; that may be the only way to prevent the government from becoming insolvent.Even to the extent that the Federal Reserve does not monetize the debt, however, adjustments in the private economy to the higher deficit policy lead to more inflation, in two other ways: by crowding out and by private monetization of debt.When additional government debt is not monetized by the Federal Reserve, the debt adds to net credit demands and raises interest rates.Higher interest rates crowd out investment in plant and equipment, which reduces the rate of real growth in the economy.With the same amount of money chasing fewer goods, prices are driven up.In the financial sector, meanwhile, higher interest rates make profitable the development of new financial instruments that make government bonds more like money.These instruments allow people to hold interest-bearing *This is a substantially revised version of a paper presented at The Economic Consequences of Government Deficits: An Economic Policy Conference, cosponsored by the Center for the Study of American Business and the Institute of Banking and Financial Markets and held at Washington University, St. Louis, Missouri, in October 1982.That paper is forthcoming in a volume of the conference proceedings.1 The Congressional Budget Office's (CBO's) baseline budget projections forfiscal years 1983-85, which are based on assumptions of no change in current laws and no change in real discretionary spending, are $194 billion, $197 billion, and $214 billion, respectively.These large baseline deficits are based on the CBO's assumption of a weak economic recovery.However, even assuming a strong economic recovery over the next three years, the CBO estimates that deficits would still be $178 billion, $155 billion, and $162 billion, respectively.(See U.S., Congress, CBO 1983).
Source: Quarterly Review
DOI: 10.21034/qr.712
Author: Preston J. Miller
Institution: Federal Reserve Bank of Minneapolis
Language: English
Domain: Social Sciences
Open Access status: bronze
OpenAlex ID: W1486581237