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Government Deficits and Corporate Liquidity: Government deficits and interest ratesGovernment deficit/spending can be positively or negatively related to interest rates, depending on the level of real interest rates (Choi and Devereux 2006). However, existing literature provides sufficient evidence supporting the positive relationship between government deficits and interest rates, concurring with the prediction of the Keynesian model (Cebula and Cuellar 2010; Correia-Nunes and Stemitsiotis 1995; Georgiou 2009a; Georgiou 2009b; Hartman 2007; Quayes and Jamal 2007). Governments are likely to lower the bond prices to induce investors to invest in government-issued bonds to finance government spending, but this increases interest rates (Saleh and Harvie 2005).
Government deficits and economic growth
Existing literature does not show a clear relationship between government deficit/spending and economic growth due to various factors. For example, previous studies have found that an increase in government spending can promote economic growth in less developed countries, whereas more developed countries are likely to experience a negative impact of increased government spending (Guseh 1997; Hassan and Strazicich 2000; Lin 1994). In addition, expansionary government spending is more likely to promote short-term rather than long-term economic growth (Choi and Devereux 2006). Furthermore, the impact of government deficit/spending on economic growth also depends on the types of government spending.
Existing studies show that government deficits induced by increased public investment can cause the marginal product of capital to rise; therefore, private investment is crowded in and economic growth should be promoted. In contrast, an increase in government deficit due to public consumption spending tends to crowd out private investment, and thus have a negative impact on economic growth (Saleh and Harvie 2005). Click Here
Regardless of the mixed results and ambiguous relationship between government deficit and economic growth, financing government spending usually results in an increase in interest rates, which results further in an increase in cost of capital and a decrease in investments and bank lending to consumers such that economic growth is hampered (Georgiou 2009a; Georgiou 2009b). In addition, the negative relationship between government deficit and economic growth should be expected because the productivity of government sector is lower than that of the private sector (Cebula 1995). Furthermore, to the extent that government deficits have an inflationary effect especially when debts are monetised, inflation is expected to be higher, such that expected real purchasing power decreases, so does future economic growth.
Lastly, empirical evidence strongly supports the conventional (Keynesian) view that government deficits lead to an increase in current account deficit. This is the so-called “twin deficits hypothesis,” that is, a strong and positive relationship exists between current account balance and government budget balance (Normandin 1999). Accordingly, GDP growth should be affected negatively because of the worsening current account deficit induced by government deficit. Hence, government deficits are more likely to have a negative impact on economic growth.