University Macroeconomics Report: Deficits, Interest Rates, and Taxes

This report analyzes Alan Reynolds' article, "Deficits, Interest Rate and Tax," examining the impact of government budget deficits on various economic variables. The report summarizes the article's core arguments, which challenge the conventional wisdom that budget deficits lead to higher interest rates, reduced investment, trade deficits, and fiscal instability. The author critically evaluates four hypotheses proposed by Robert Rubin, Peter Orszag, and Allen Sinai, using U.S. data and international comparisons. The report finds that the evidence does not support these hypotheses. Furthermore, the report links the article's concepts to course content, other academic literature, and real-world examples, including the cases of Venezuela and China. The report concludes by emphasizing the ongoing debate regarding the impact of budget deficits on economic variables, despite the article's findings.

Running head: MACROECONOMICS
Macroeconomics
Name of the Student
Name of the University
Course ID

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Table of Contents
Introduction......................................................................................................................................2
Article Summary..............................................................................................................................3
Deficit and Interest rate...............................................................................................................3
Budget deficit and private investment.........................................................................................3
Budget deficit and trade balance..................................................................................................3
Budget deficit and market confidence.........................................................................................4
Link with the course....................................................................................................................4
Phenomena explained in the article.............................................................................................4
Critical commentary about the article..........................................................................................5
Link with literatures and real economy...........................................................................................5
Real world example.....................................................................................................................5
Conclusion.......................................................................................................................................8
References........................................................................................................................................9

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Introduction
The article named ‘Deficits, Interest Rate and Tax’ by Alan Reynolds brought the
important issue related to impact of budget deficit on different economic variable. Government
of a nation uses fiscal policy measure to support the economy. The fiscal policy measures
include variation in government expenditure or tax rate. Excessive spending over revenue results
in a budget deficit. There is growing concern regarding the possible negative bearing of deficit
budget on the economy. It is widely argued that budget deficit causes an increase in interest rate,
lowers the economic growth, widens trade deficits and possibly leads to financial crisis. In this
connection the chosen article examines the mentioned claim regarding possible impact of budget
deficit in the context of federal government’s budget. The article critically evaluates proposition
of a recent study conducted by Robert Rubin, Peter Orszag and Allen Sinai related to economic
impacts of budget deficit. The study by Robert Orszag proposed four hypotheses. These are:
first, an estimated budget deficit has implication for interest rate, second, smaller amount of
deficit leads to larger domestic investment, third, budget deficit leads to trade deficit and fourth,
budget deficit represents fiscal disarray and needs an increase in tax to maintain fiscal
confidence. The article has not found support of the hypotheses from U.S. data. In order to
extend the discussion and establish its connection with the existing literatures, the paper has
linked the article with two other selected article on the same topic. Finally, hypotheses of the
existing literatures are examined by connecting the concepts to the real world economy.

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Article Summary
Deficit and Interest rate
The first hypothesis that the article examine is the one describes connection between
interest rate and budget deficit. It is argued by some economists that current budget deficit has a
tendency to increase interest rate in the long term. Two new variations are proposed by Sinai,
Orszag and Rubin on the existing theory. They proposed that real interest rate tends to increase
due to an estimated increase in future budget deficit. This leads to a change in the spread
between long term and short term interest rate. The article however found that real or nominal
interest rate are affected neither by actual nor by estimated interest rate. The article by claiming
such an argument a completely flawed rejected the proposed hypothesis.
Budget deficit and private investment
The second hypothesis states that a smaller budget deficit automatically results in a larger
private investment irrespective of the fact that whether they are attained at a means of fiscal
policy contraction (higher tax or contraction of spending). The evidence from US however did
not support the claim. Saving rate in US was 18.2 percent between 1981 and 1989 with an
average budget deficit of 3.8 percent (Reynolds, 2004). However, between 1998 and 2001, there
was a surplus in budget the saving rate however was 18 percent.
Budget deficit and trade balance
The third hypothesis proposes that a large amount of budget deficit results in trade deficit
or current account deficit. The concept of twin deficit has also not been supported when
evaluated using data on US.

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Budget deficit and market confidence
Persistent fiscal deficit causes a loss of confidence for the market participants. The
solution to this problem lies in increase in the tax rate to regain confidence. The article rejected
the idea that increase in tax help to regain the fiscal confidence in connection to the event of
stock market crash in 1987.
Link with the course
One important course content is the government policy intervention in the economy and
its impact. Government in an economy intervenes either by fiscal or by monetary policy. The
fiscal policy tools are spending of government and tax. During economic downturn government
takes expansionary fiscal policy which requires either expansion of government spending or cut
in tax rate (Heijdra, 2017). This kind of policy may result in government budget deficit by
increasing cost burden of government. The article by evaluating consequences of budget deficit
on other economic variables helps to understand effectiveness of such policy measure in real
world.
Phenomena explained in the article
The article seeks to explain economic impact of government budget deficit taking into
consideration federal government’s budget. The article examines consequences of government
budget deficit for interest rate, saving and investment, trade deficit and fiscal position. The
article considers the claim made by Rubin, Orszag and Sinai regarding the impact of deferral
budget deficit on the concerned variables. The proposed impacts are evaluated using theoretical
and empirical evidences (Reynolds, 2004). The impact on budget deficit on interest rate has been

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evaluated using yield curve. The article has tested the claim of twin hypotheses to assess the
linkage current account deficit and budget deficit.
Critical commentary about the article
Main strength of the article is that it has examined each of the four proposed hypotheses
separately and examined the proposed interconnection of budget deficit with interest rate, trade
deficit, investment and fiscal position. The discussion is not limited to evidences from U.S. only.
Rather it considers experience of other countries as well. One drawback of the article is that it
has not attempted to develop any empirical model. No statistical analysis has been conducted by
the authors to investigate the relation between study variables.
Link with literatures and real economy
Similar to the chosen article, there are past literatures that studied consequences of budget
deficit. One study conducted by Gebremariam (2018), examined the impact of government
budget deficit on current account deficit for Ethiopia considering data for the period ranging
from 1976 to 2015. The paper adapted vector error correction model to find the relation between
budget deficit and current account deficit (Gebremariam, 2018). The paper found a negative and
statistically insignificant relation between budget deficit and current account deficit. The paper
however found a statistical significant bi-directional causality between the two.
Another paper developed by Bayat, Kayhan & Senturk (2012), studied the impact of
budget deficit on interest rate taking into consideration the case for Turkish economy. The
sample period used in the paper ranged from 2006 to 2011. Statistical analysis of the paper
concluded that no causal relation exits between nominal interest rate and government budget
deficit (Bayat, Kayhan & Senturk, 2012). The article supported equivalent hypothesis as

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proposed by Ricardo and suggests that type of financing the budget deficit does not influence
interest rate in the economy.
Real world example
In order to examine the impact of government budget deficit on the economy budget
deficit of two countries are taken into consideration. Venezuela and China are the two nations
that have experienced as increasing share of government budget deficit (Vera, 2017). The impact
of widening budget deficit on selected economic variables has been observed by considering the
trend of last 25 years.
Venezuela
Figure 1: Government budget deficit
(Source: tradingeconomics.com, 2020)

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Figure 2: Trade deficit
(Source: tradingeconomics.com, 2020)
Two figures above indicate that despite an increase in budget deficit, trade balance of
Venezuela remains in surplus (Banday & Aneja, 2019) This falsifies the claim that government
budget deficit increases trade deficit.
China
Figure 3: Government budget deficit
(Source: tradingeconomics.com, 2020)

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Figure 4: Investment in China
(Source: tradingeconomics.com, 2020)
In case of China, increase in government budget deficit is accompanied with an increase
in private investment. This rejects the claim that budget deficit has to be smaller to increase
saving and investment.
Conclusion
The paper has attempted to analyze the article ‘Deficits, Interest Rate and Tax’ by Alan
Reynolds based on the impact of government budget deficit on some of the selected economic
variables. The article critically examined four hypotheses budget deficit with interest rate, saving
and investment, trade deficit and fiscal confidences. Considering the theoretical and empirical
evidences the article has rejected all the four hypotheses. The article however can be criticized
on the ground that it has not developed any statistical model to validate the claims. There are past
literatures in this field giving the similar conclusion. In China and Venezuela, two countries
having a continuously increasing budget deficit, the deficit has no impact on investment and

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current account deficit. Therefore, the actual impact on a growing deficit on other economic
variable is still subject to an open debate.

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References
Banday, U. J., & Aneja, R. (2019). Twin deficit hypothesis and reverse causality: a case study of
China. Palgrave Communications, 5(1), 1-10.
Bayat, T., Kayhan, S., & Senturk, M. (2012). Budget deficits and interest rates: An empirical
analysis for Turkey. Eurasian Journal of Business and Economics, 5(9), 119-128.
Gebremariam, T. K. (2018). The Effect of Budget Deficit on Current Account Deficit in
Ethiopia: Investigating the Twin Deficits Hypothesis. International Journal of
Economics & Management Sciences, 7(530), 2.
Heijdra, B. J. (2017). Foundations of modern macroeconomics. Oxford university press.
Reynolds, A. (2004). Deficits, Interest Rates, and Taxes: Myths and Realities. Cato Institute.
tradingeconomics.com (2020). China Government Budget | 1988-2018 Data | 2019-2020
Forecast | Historical | Chart . (2020). Tradingeconomics.com. Retrieved 5 April 2020,
from https://tradingeconomics.com/china/government-budget
tradingeconomics.com (2020). China Gross Fixed Capital Formation | 1952-2018 Data | 2019-
2020 Forecast | Historical . (2020). Tradingeconomics.com. Retrieved 5 April 2020,
from https://tradingeconomics.com/china/gross-fixed-capital-formation
tradingeconomics.com (2020). Venezuela Balance of Trade | 1990-2019 Data | 2020-2022
Forecast | Historical | Chart . Tradingeconomics.com. Retrieved 5 April 2020, from
https://tradingeconomics.com/venezuela/balance-of-trade

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tradingeconomics.com (2020). Venezuela Government Budget | 1990-2015 Data | 2019-2020
Forecast | Historical | Chart. Tradingeconomics.com. Retrieved 5 April 2020, from
https://tradingeconomics.com/venezuela/government-budget
Vera, L. (2017). In search of stabilization and recovery: macro policy and reforms in
Venezuela. Journal of Post Keynesian Economics, 40(1), 9-26.