The impacts of federal budget deficit on macroeconomic variables: An empirical study

This dissertation discusses the impacts of federal government budget deficit on macroeconomic variables. I begin with a baseline model that includes the real total federal government budget deficit, real current account balance, real interest rate, real exchange rate, and real GDP. The variables chosen correspond to those in the Mundel-Fleming model. The data sets for all variables are quarterly for the period 1980: I to 2004: IV.

This dissertation focuses on testing for multivariate cointegration in the five-variable system, and, finding it, also, estimating a vector error-correction (VEC) mechanism to produce variance decomposition, impulse response functions, and Granger-Causality tests. Since the results of such VEC estimations typically are sensitive to lag lengths and the ordering of the variables, the effects of altering lag lengths and variable orders are considered. Finally, the study examines the impacts of substituting private consumption for GDP in the five-variable system.

The study used the methodology of Johansen, and Johansen and Juselius to test for the presence of cointegration in the five-variable system. The test shows a single cointegrating vector for the five-variable system.

The presence of cointegration in the five-variable system leads to apply a vector error correction (VEC) mechanism rather than a conventional unrestricted vector autoregression (UVAR) specification. Using a VEC model we can analyze the short-run dynamics of the relationship between the five variables included in the system by producing variance decomposition, and impulse response functions. Also by applying the Granger Causality tests we can determine the direction of the causality. The variance decomposition gives information about the relative importance of the random innovations. It shows the sources of errors in forecasting a dependent variable. Results show that federal budget deficit appears to have some degree of significant explanation in forecasting error variance of interest, and exchange rates. However the federal budget deficit appears to have a weak and small impact on the current account balance and GDP. Impulse response functions trace the responses of endogenous variables to the change in one of the innovations in a system. In other words, an impulse response function traces the effect of one standard deviation shock to one of the innovations on current and future values of the endogenous variables.

Results show that the initial effects of a shock to the federal budget deficit on interest rates are positive and statistically significant for two quarters; this means an increase in the budget deficit leads to a rise in interest rates. The impact of deficit on the exchange rate appears to be negative and permanent, and the impact is statistically significant for at least five quarters. The increase in deficit leads to depreciate the exchange rate. The impact of deficit on the current account balance appears to be statistically not significant, but the direction of impulse response is positive for at least five quarters; this means that budget deficit increases the current account balance, and the impact after five quarters appears to be negative, which means budget deficit worsens the current account after five quarters. The last one is the impact of deficit on the GDP, which appears to be permanent negative and statistically significant for at least three quarters. The increase in budget deficit leads to decrease the GDP.

Granger causality results show that budget deficit does not cause an increase in the interest rate, exchange rate and GDP. It shows that budget deficit causes current account deficit and also, results show that the interest rate, exchange rate, and the GDP cause current account deficit. Tests also show that the interest rate causes exchange rate appreciations, and the GDP causes budget deficit. An interesting finding here is that the interest rate plays an important role in the movement of the exchange rate, current account and GDP.

Substituting private consumption for the GDP and analyzing the impact of deficit on the interest rate, exchange rate, current account, and private consumption using the same techniques explained above provides different results. Cointegration test shows the data have one cointegrating vector based on trace test, and two cointegrating vectors based on the eigenvalue test. The dynamic analyses were based on two tests.

Based on the variance decomposition, it appears to be that budget deficit explains the movements in private consumption by including one or two cointegrating vectors. Impulse response functions appear to be statistically significant of the impact of budget deficit on private consumption. Impulse response shows that the impact is permanent, positive and statistically significant for at least seven quarters based on one cointegrating vector, and for at least five quarters based on two cointegrating vectors. This can be explained by the traditional Keynesian view that asserted budget deficit was net wealth. Based on Granger causality test, results are different, which appears to show that deficit does not cause an increase in private consumption based on one cointegration vector, but deficit causes an increase in private consumption based on two cointegrating vectors. In general and based on the tests applied, the results show that budget deficit plays a small role in determining the macroeconomic variables.