Long Term Effects

Future Living Standards

• Reduced because of:

1. Slowed accumulation of wealth due to lowered national saving
2. Decrease in labor productivity due to a reduction in domestic investment

National Saving

National Saving = Private Saving + Government Saving

If all other parts of national saving remain unchanged, as the federal deficit rises, national savings will fall as a result of resources being shifted into public and private consumption.

Reasons for shifts from saving to consumption:

1. reductions in taxes → increase private consumption
2. increases in government spending for federal entitlement programs → increase private consumption
3. increases in government purchases → increase government consumption

Note: This switch from saving to consumption occurs regardless of whether the increased deficit is the result of increased current federal spending or tax reductions. The decrease in national saving results from the deficits' tendency to raise the fraction of income that is consumed.

Private Saving

The degree to which private saving changes in response to changes depends upon both the current policy changes as well as peoples' perceptions about future policy actions.

Productive Capacity and Capital Inflows

Large and persistent federal deficits lower the amount of resources that US residents can devote to investment in productive capacity.

Affects of domestic investment (private and public)

• On the growth of US output and productivity:
  • raises Labor Productivity
    • for a given level of technology, an increase in capital raises output per worker
  • raises Total Factor Productivity growth
    • new capital often leads to the introduction of new technologies into the production process

• Offsetting of adverse effects:
  • Net capital inflows from abroad tend to rise as US saving falls
    • additional investment opportunities open up for foreigners as US saving falls
    • foreign capital finances investment that under prevailing market conditions would otherwise not be funded

Example: 1983-present

The downward trend in gross national saving has beeb accompanied by an upward trend in net capital inflows. On average, each decline in gross national saving equal to 1.0% of GDP has been offset by an increase in net capital inflows from abroad amounting to 0.4% of GDP. By financing domestic investment in productive capacity, the increase in net capital inflows has supported labor productivity and the income of workers when the national saving rate falls. However, this also increases the level of US foreign indebtedness. Capital inflows only partially offset the loss of future living standards that result from the adverse effects of federal deficits on national saving because future payments to foreigners will be paid out of future national income generated by the investment financed by capital inflows. Even still, given low national saving, the US is better off as a result of capital inflows.

Financial Markets

In changing national saving, investment, and net capital inflows, federal deficits also affect:

• Interest Rates
• Exchange Rates
• Stock Market Values

• Increasing the demand for credit → higher interest rates

• higher interest rates tend to attract foreign capital, putting upward pressure on the US dollar

• Decrease in capital accumulation → fall in stock market values

• however, the federal deficit is not nearly as important as other factors in determining movements in the stock market

• Movements in financial-market variables help to restore balance between the amount of investment demanded and desired national saving plus net capital inflows

• Sensitivity of financial variables dictate how much interest rates, exchange rates and stock market values need to change in order to restore balance.

• For example, the response of net capital inflows can dampen movements in the interest rate, moderating the extent to which domestic investment is crowded out.

Even with small movements in the interest rates, the federal deficit can significantly impact the future living standards because of its impact on national saving and wealth accumulation. A sustained federal deficit amounting to 1.0% of GDP raises the interest rates by 0.2% to 0.6%.