The impact of government deficits when credit markets are imperfect: Evidence from the interwar period

Abstract

A counterfactual assumption underlying Ricardian and Neoclassical approaches to the role of deficits is that credit markets are perfect. While it is frequently asserted that the Ricardian neutrality result is invalidated by credit market imperfections, the theoretical literature suggests that this is ultimately an empirical question. However, almost no empirical evidence has been presented. This paper uses vector autoregressive models of the interwar macroeconomy to evaluate the role of deficits. Deficits are found to have important second-order effects on output, interest rates, and prices when credit market imperfections are accounted for, and little impact when they are ignored.