Possible Macroeconomic Consequences of Large Future Federal Government Deficits

Abstract

This paper uses a macroeconometric model of the U.S. economy to analyze possible macroeconomic consequences of the large future federal government deficits. The analysis has the advantage of accounting for the endogeneity of the deficit. The results are bleak. Assuming no large tax increases or spending cuts and no bad dollar and stock market shocks, the debt/GDP ratio rises substantially through 2020. These estimates are in line with other estimates.

If the dollar depreciates in response to the deficits, inflation increases but the effect on the debt/GDP ratio is modest. It does not appear that the United States can inflate its way out of its deficit problem. If in addition U.S. stock prices fall, this makes matters worse by lowering output. Large personal tax increases or transfer payment decreases solve the deficit problem, but at a cost of considerable lost output over a decade. The Fed's ability to offset these losses is modest according to the model. Introducing a national sales tax is more contractionary than is increasing personal income taxes or decreasing transfer payments.

Keywords: federal deficit, federal debt

JEL Classification: E17