How Budget Deficit Impairs Long-Term Growth and Welfare under Perfect Capital Mobility

Abstract

This paper investigates the implications of the size of budget deficit in the
open economy under perfect mobility of capital. For that purpose we construct
a general equilibrium model with consumers maximizing the discounted utility
of consumption, and firms maximizing profits. Government sets the size of
the deficit relative to GDP and controls the structure of public debt. Using
standard methods of optimal control theory we solve the model, i.e. we find
explicit formulas for all trajectories and the level of welfare. Finally, we show
that the higher the deficit-to-GDP ratio, the lower the welfare of consumers.
Similarly, welfare increases with the share of foreign creditors in public debt.