Budget Deficit in a Growing Economy and Impossibility of Fiscal Collapse: A Continuous Time Analysis

Abstract

Abstract Using a continuous time dynamic model of growing economy we will show the following results. 1) When people derive utility from their money holding (or government bond holding) along with their consumption, a budget deficit is essential to achieve and maintain full employment under stable prices or inflation in a growing economy. 2) If we take into account that government spending due to budget deficits increases financial assets held by the private sector, and then consumption will occur from assets in addition to consumption from income, even when the interest rate on government bonds is higher than the real economic growth rate, the ratio of government debt to GDP can not diverge and the divergence is naturally prevented by mild inflation. The required inflation rate is such that the interest rate of the government bonds is smaller than the weighted average of the rate of return on capital and the nominal growth rate. Since the interest rate of the government bonds is usually considered smaller than the rate of return on capital, this is not a very demanding requirement. Thus, we need not worry at all about the accumulation of government debt or about the divergence of the debt to GDP ratio, which is often taken as an indicator of fiscal collapse.