An open economy is an economy that interacts freely with other economies around the world by buying and selling goods and services in the world product market and also buys and sells capital assets in the world financial market. It has free interaction with foreign sectors. A government budget deficit occurs when the government spendings exceed the government revenue. It is representative of negative public saving and therefore the national saving is also reduced as it is a sum of public and private savings. Keynesian theory supported that in a period of economic crisis, the government must take up deficit spending to compensate for the declining investment and boost consumer spending to stabilise aggregate demand.
This has led to a lot of criticism due to the long-lasting consequences that follow. The short term benefits vary depending on the nature of the deficit, however, at times certain sectors do benefit from the deficit in the short term. The bright side of Budget deficits being enforced by the government depending on the purpose may lead to expanding policies that promote social welfare, build infrastructure, finance wars, maintain environmental protection, and other public centric works.
Whereas for the long term effects, taking an example of the US as an open economy having a government budget deficit I will assess the effects that a government budget deficit has. To finance a deficit the government will have to sell its securities which are purchased by individuals and businesses resulting in a reduced supply of loanable sums available that can be lent elsewhere. The potential capital stock of the economy is reduced. As a result, this crowds out the investment and also causes the interest rate to drive up. This in turn distorts the marketplace.
In an open economy, the reduced supply of loanable funds causes a fall in the net capital outflow as the idea of investing abroad seems less desirous causing lesser people to buy foreign assets. This also creates a rise in interest rates. The level of higher interest rates then attracts foreign investors who wish to earn higher returns on US assets. However, in general, the trend is that the higher interest rate also causes a reduction in net foreign investment.
Due to the reduced net capital outflow, Americans require less foreign currency to purchase any foreign assets which cause lesser American dollars to be floated in the market for foreign currency exchange. The value of the dollar becomes superior to other foreign currencies and this causes US goods to be more expensive. When this happens, there is a switch by domestic residents and foreigners from buying these expensive goods. This causes a rise in imports and a decline in exports. It also leads to an appreciation of the real exchange rate as the decrease in net foreign investment reduces the supply that is to be exchanged into foreign currency. This results in a deficit in the trade balance. Higher interest rates result in lesser private investment and higher exchange rates all of which results ultimately in fewer exports. The level of unsustained public debt that accompanies this problem is also a major concern as the correction of such a deficit may require the government to cut back on spending and increase activities that generate revenue. A budget deficit may also be accompanied by a trade deficit as there is an inflow of foreign investments and with the exports remaining either fixed or being reduced, foreigners have an increased hold of the dollar with residents purchasing goods that are imported. The decreased investment in physical capital leads to lower levels of business investment.
Therefore, in an economy when a government budget deficit takes place it raises the real interest rate, crowds out the domestic investment, cause the currency to appreciate, and pushes the trade balance toward deficit. All of these effects cause the economy to slow down and result in a reduced productive capacity of the economy.
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