Federal Budget Deficits, Interest Rates, and Inflation: Their Implication for Growth

The persistence of large federal government deficits has stimulated interest in investigating the impact of deficits on the U.S. economy. The present paper analyzes two related theoretical issues. First, it examines the direction of causal flows in the deficit-nominal interest rate relationship. Second, it investigates the effects of deficits on the two components of nominal interest rates, namely the inflation rate and the real rate of interest. The causality test results indicate that deficits affect both of these components in the case of the long-term nominal interest rate. Deficits have adverse effects on economic growth because of reduced capital formation at higher real rates of interest.