Economic Growth

The impact of the budget deficit on economic growth is theoretically explained through the effect of the deficit on the flow of money into the economy and through the supply side (infrastructure, education, etc). The more that government expenditure exceeds revenue the more money will be circulated in the economy, which leads to higher employment and output (McCandless, 1991). Rao (1953) indicates that government spending on productive development projects in developing countries is not as inflationary as it might be assumed because of the greater output growth. Eisner and Pieper (1987) report a positive impact of cyclically and inflation-adjusted budget deficit on economic growth in the United States and other Organization for Economic Cooperation and development (OECD) countries. Arora and Dua (1993) examined effect of budget deficit on investment and on trade balance in the U.S. during the period from 1980 to 1989. The results suggest that higher budget deficit crowd out domestic investment and increase trade deficit. Shojai (1999) in his study concluded that budget deficit, financed by the central bank, can also lead to ineffectiveness in financial markets and rises inflation in the developing countries. Budget deficit also pervert real exchange rates and the interest rate, which in turn undermines the international competitiveness of the economy. Recent studies, such as the World Economic Outlook (IMF, 1996); found that in the mid-1980s, a group of developing countries with high level of budget deficit had significantly lower economic growth than in countries with low and medium deficit. Karras (1994) investigated the effects of budget deficit on money growth, inflation, investment, and real output growth. Author came to conclusions that deficit do not cause high inflation through monetary expansion; deficit has a negative relationship with real output growth rate; and increased deficit do appear to slow down investment usually after one or two years. Fischer (1993) proves the opposite of theoretical prediction, on a consistent sample of countries. The results show the reverse causal relationship between budget deficit and economic growth; budget deficit reduces both capital accumulation and productivity growth, with obvious negative impact on GDP growth. Adam and Bevan (2005) investigated the relationship between budget deficit and economic growth for a group of 45 developing countries and identified that two variable have a contrary causal relationship, and a level of deficit below which causality is blurred. The results imply that reduction of budget deficit level to about 1.5% of gross domestic product is apparently has a positive impact on the growth rate of GDP. A reduction in budget deficit below this limit, not only no longer produces positive effects on economic growth, but can also actually be detrimental if the reduction is due to a significant fiscal contraction. Brauninger (2002) conducted a study on the relationship between budget deficit, public debt and endogenous growth. The result shows that if the deficit ratio fixed by the government stays below a critical level, then there are two steady states where capital and public debt grow at the same constant rate, and an increase in the deficit ratio reduces the growth rates

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Trade balance

“Studies of the twin-deficits relationship generally proceed from one of two theoretical bases. The hypothesis that increases in the government’s budget deficit leads to an increase in the trade deficit follows directly from the Mundell- Fleming model (Fleming, 1962; Mundell, 1963). It is worth noting here that the Mundell-Fleming model is an open economy extension of the IS-LM model. As such, it is not fully “rational”; the assumptions made regarding expectations formation are static. According to Mundell-Fleming, an increase in the state’s budget deficit can generate an accompanying increase in the trade deficit through increased consumer spending. By increasing the disposable incomes and the financial wealth of consumers, the budget deficit encourages an increase in imports. To the extent that increased demand for foreign goods leads to depreciation in the exchange rate, the effect on net exports is mitigated. However, the larger budget deficit also pushes up the interest rate (in large open economies) because this appreciates the exchange rate, which encourages a net capital inflow and a larger decline in net exports. The size of the effect is an empirical matter (Shojai, 1999, p. 92).” (Saleh, 2003, p.13).