Fiscal deficits and macroeconomic performance in developing countries

William Easterly, Klaus Schmidt-hebbel

    Research output: Contribution to journalArticle

    Abstract

    Although fiscal adjustment was urged on developing countries during the 1980s to lead them out of economic malaise, considerable uncertainty remains about the relations between fiscal policy and macroeconomic performance. To illustrate how financial markets, private spending, and the external sector react to fiscal policies, the behavior of holdings of money and public debt, private consumption and investment, the trade balance, and the real exchange rate is modeled for a sample of ten developing countries. The studies find strong evidence that over the medium term, money financing of the deficit leads to higher inflation, while debt financing leads to higher real interest rates or increased repression of financial markets, with the fiscal gains coming at increasingly unfavorable terms. Consumers respond differently to conventional taxes, unconventional taxes (through inflation or interest and credit controls), and debt financing, in ways that make fiscal adjustment the most effective means of increasing national saving. Private investment-but not private consumption-is sensitive to the real interest rate, which rises under domestic borrowing to finance the deficit. Contrary to the popular presumption, in some countries private investment increases when public investment decreases. There is strong evidence that fiscal deficits spill over into external deficits, leading to appreciation of the real exchange rate. Fiscal deficits and growth are self-reinforcing: good fiscal management preserves access to foreign lending and avoids the crowding out of private investment, while growth stabilizes the budget and improves the fiscal position. The virtuous circle of growth and good fiscal management is one of the strongest arguments for a policy of low and stable fiscal deficits.

    Original languageEnglish (US)
    Pages (from-to)211-237
    Number of pages27
    JournalWorld Bank Research Observer
    Volume8
    Issue number2
    DOIs
    StatePublished - Jul 1993

    ASJC Scopus subject areas

    • Development
    • Economics and Econometrics

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