COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1727

Possible Macroeconomic Consequences of Large Future Federal Government Deficits

Ray C. Fair

September 2009
Revised October 2009

This paper uses a macroeconometric model of the U.S. economy to analyze possible macroeconomic consequences of large future federal government deficits. The analysis has the advantage of accounting for the endogeneity of the deficit. In the baseline run, which assumes no large tax increases or spending cuts and no bad dollar and stock market shocks, the debt/GDP ratio rises substantially through 2020. The estimates from this run are in line with other estimates. Various experiments off the baseline run are then done. If the dollar depreciates, 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 because of a negative wealth effect. 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