VYTAUTAS MAGNUS UNIVERSITY

FACULTY OF ECONOMICS AND MANAGEMENT

DEPARTMENT OF ECONOMICS

Miras Bazikenov

THE EFFECT OF THE GOVERNMENT BUDGET DEFICIT ON

ECONOMIC GROWTH

Term Paper

Advisor: dest. dokt. Justinas Kisieliauskas

Kaunas, 2017
 CONTENTS

INTRODUCTION 4
THEORETICAL FRAMEWORK
I. BUDGET DEFICIT 5
II. ECONOMIC APPROACHES TOWARDS THE EFFECT OF THE BUDGET 7
DEFICIT
EMPIRICAL RESEARCH
III. METHODOLOGY 11
IV. THE BUDGET DEFICIT ANALYSIS OF EU-28 COUNTRIES 12
CONCLUSION 17
REFERENCE LIST 18
ANNEXESS 20
Annex 1 20
Annex 2 21
Annex 3 23
Annex 4 24
Annex 5 26
Annex 6 27
Annex 7 29
 Abstract

Author of term paper: Miras Bazikenov

Full title of term paper: The effect of the government budget deficit on economic growth

Term paper advisor: dest. dokt. Justinas Kisieliauskas

Presented at: Vytautas Magnus University, Faculty of Economics and

Management, Kaunas, 2017

Number of pages: 18

Number of tables: 7

Number of pictures: 1

Number of annexes: 7

From time to time, we hear from the news about some economies which face budget deficit
and their reaction towards its solution. As we know, a big part of developed countries have a budget
deficit instead of budget surplus, for example the United States, what means that in these countries
government expenditures exceed government revenues. But what means government budget deficit
for these economies? Does it show ineffective fiscal policy of the state? Is it good or evil for their
economic perspectives. According to economic theory budget deficit is not a certain case and it can
not be always treated as a negative outcome, however it does not signify that budget deficit has a
neutral effect. Therefore, in this term paper, the main aim to investigate the relationship between
government budget deficit and its impact on economic growth.
Keywords: budget deficit, government revenue and expenditure, economic growth
 INTRODUCTION
Nowadays, in the developing world, government budget deficit is one of the most interesting
economic issues that can be differently treated. It is known fact that budget plays a huge role in
perspectives of any financial institution and public budget is not an exception. Budget is estimation
of revenues and expenditures of the state during a specific period of time. According to this
definition, it can be said that budget deficit is a situation when government spending surpass income
that can lead to different economic outcomes. But the main question is how important the effect of
government budget deficit on economic variables. During the Great Recession, the United States
faced a new for its time economic disaster. Fiscal policy which was offered by Keynesian
economists pulled out the US economy from poor economic situation. The significance of budget
deficit spending had an incredible effect on economic growth of the US. However, over some years,
the US started to suffer from having budget deficit (high inflation rates) and it was strongly
criticized by American economists as Milton Friedman. At the end the fiscal policy was changed.
This historic overview was given to see that the effect of budget deficit can be very controversial.
The main idea of investigating the effect of budget deficit on economic growth is estimation
of economic impact which can be possessively and negatively described. For example, in Canada
from 1975 to 1997 government faced a huge budget deficit which consequently leaded government
debt. When government runs a deficit, it will try to cover its debt by borrowing from the public and
selling its bonds that directly affects investment potential of the state. If the state has a decreasing
investment, interest rate will increase. Such situation pushed Canadas economy to bad shape where
budget deficit caused lower economic growth. (Hoffman, Yescombe, 2012). Based on given
information, it is shown how public budget deficit leads several serious economic consequences
such as decrease of investment, increase of interest rate and public debt.
The main objective of term paper to find a correlation between public budget deficit and
economic growth. As it was seen before, large budget deficit can poorly influence on economic
growth, however it does not say that any budget deficit behaves similarly. To provide all possible
effects of public budget deficit it will be considered the Keynesian, Neoclassic and Ricardian views
towards finding a link between budget deficit and economic growth.
In this study, it will be used panel data for investigating the effect of budget deficit on
economic growth where a data is taken from Eurostat and OECD databases of the European Union
(EU-28) from 2009-2015.
 THEORETICAL FRAMEWORK
I. BUDGET DEFICIT
Firstly, to start analyzing the current research it is compulsory to comprehend the meaning of
budget deficit and its meaning.
In the simplest way, budget deficit can be explained as the context when government in order
to balance budget borrows money which leads to as known public sector net borrowing or budget
deficit. Budget deficit occurs while government expenditure exceeds government revenues. (Keep,
2017)
Budget deficit has different effects on the economy of the state. Ball and Mankiw (1995)
affirms that budget deficit has a several instant effect on the economy. When government runs
budget deficit it decreases national savings. The reduction of national savings must decline
investment, net exports or both. Consequently, budget deficit creates the trade deficit where imports
exceed exports. The state becomes an importer of goods and services while assets are exported
abroad. Moreover, as it was said previously it decreases investment by affecting interest rate. The
simplest explanation comes from an assumption that decline in national savings also diminishes
supply of loans to private sector which increases interest rate. High interest rate can not be a good
option for borrowing and private consumers tend to not invest. In addition, high interest rates
appreciate domestic currency because domestic bonds become more attractive and increase demand
for domestic currency in the market of foreign currency. Thus, domestic goods cost more expensive
comparing to foreign goods and it makes less export and more import. Overall, a budget deficit
affects economy by decreasing national savings, investment and net exports. Furthermore, it
outflows domestic assets, boosts interest rate and appreciates domestic currency.
In contrast to Ball and Mankiw, Eisner and Pieper (1984) states that increase in budget deficit
spending can not be badly criticized due to a fact of lagged influence of budget deficit on economic
variables. It is true that immediate outcomes of budget deficit can be negative in economic point of
view, although it must be considered that not all economic variables instantly reveal positive effects.
It is stated that in 1980s the US resulted high employment budget surplus, even though the fiscal
policy of the US focused on the budget deficit spending. The results of budget deficit can not
always treated as negative economic outcome because the results are highly depended on the fiscal
policy of the state.
Moreover, the effect of budget deficit also depends on the way of financing the budget deficit.
According to Fischer and Easterly (1990), to finance the budget deficit can be used 4 different
methods. The first is money printing. The process when government increases budget through
money printing called as seigniorage. Generally, the printing of money mechanically rises money
supply in the economy. According to Keynesian theory, during time of economic recession
increased money supply does not negatively affect prices and increase income and output. In short
run, potential increase of income will rise tax revenues. Thus, budget deficit decreases as long as
inflation rate will not hit a peak. Therefore, Fisher and Easterly stated that the amount of revenue
which can be received is primarily depends on several factors: the demand for base money, the
economic growth rate and the elasticity of the demand for real balance with regards to inflation and
income. In long run, the increase of inflation rate gains less revenue to budget and drives economy
to hyperinflation.

Figure 1. Revenue from Seignorage

Source: The Economics of the Government Budget Constraint, The World Bank Research
Observer, Vol. 5, No. 2 (Jul., 1990), pp. 127-142. Link:http: //www.jstor.org/stable/3986443

The second method is running down of foreign exchange reserves. Government can slow down
inflationary effect of the budget deficit by reducing foreign exchange reserves instead of printing
money. Due to this method exchange rates are appreciated to diminish inflation rate. Such policy is
only possible if the fiscal policy of a given state is consistent with low inflation. However, it can
lead bad economic conditions, because a huge reduction of foreign exchange reserves creates a
devaluation of the currency, capital outflow and balance of payments crisis.
The third way of financing is direct foreign borrowing. In this case the budget deficit is
financed by borrowing from foreign or international financial organizations such as International
Monetary Fund, the World Bank, the London Club and etc. Advantages of the direct foreign
borrowing are in possibility of receiving a large sum of money, noninflationary character of
borrowing. Disadvantages is necessity of returning the debt and its interests, which can lead to
economic downturn. Furthermore, it can drive to depletion of gold reserves of the state during the
deficit of balance of payments. Foreign borrowing appreciates exchange rates which badly affect
trade balance of the state. Mostly, it creates a condition where it is rather difficult to export and
easier to import goods and services. Moreover, one of the dangers is provoked by using direct
foreign borrowing is debt crisis.
The last method of financing the budget deficit is domestic borrowing. This way of financing
the budget deficit is determined on selling government assets and bonds to individuals and using
revenues to cover deficit. It does not lead to inflation, since the money supply does not change.
Additionally, people tend to purchase government assets and bonds, because government assets and
bonds are highly liquid, reliable and profitable. However, this method has different hidden
obstacles. One of them is crowding out effect. Private investment is crowded out from the
financial market by selling government bonds. People buy government bonds instead of private
bonds that decreases investment in private sector.
As it is seen above, a budget deficit can not be treated as a good tool of enhancing current
economic growth. It badly influences on major economic variables and it can not be ignored.
Therefore, there must be a good reason for running budget deficit because it is one step towards
economic crisis.

II. ECONOMIC APPROACHES TOWARDS THE EFFECT OF THE

BUDGET DEFICIT
In the history of economics it is widely seen the strong relationship between budget balance
and economic growth. Therefore, the main economic schools as Keynesian and Neoclassical have
their divers view on budget deficit.
Starting from Keynesian school, it can be said that Keynesian Theory was based on attempt to
comprehend the Great Depression. Keynes theory claimed that decline of aggregate demand is one
of the main reasons for an economic recession. According to his ideas, increasing public budget
deficit spending and cutting taxes will recover the economy. Therefore, Keynesian economist affirm
that demand plays more significant role in growth of production than supply.
Turning to budget deficit, Keynesian school has a strict view that should be particularly
explained. It is obvious that Keynes became broadly known because of his paper The General
Theory of Employment, Interest and Money, where the importance of budget deficit was clearly
explained and shown its impact on economic growth restoration. In this research, Keynes stated that
government should intervene in the economy that was contrary to thoughts of classical economic
school.(Bartlett, 2010)
Most economists criticize Keynes theory of budget deficit, because in their view, budget
deficit spending was not a solution for economic crisis, because it drives to a high inflation.
Though, it should be considered the path of solution from economic downturn. In accordance with
Lee (2012), Keynes theory based on claim that during economic recession public budget spending
should be enlarged to increase aggregate demand through dropping taxes and more government
spending. This conditions will increase the aggregate demand that exceeds productive capacity of
the state and economy will turn to full employment. However, such actions run inflation. To stop
inflation, Keynes supposed that government can decrease public demand by rising taxes and less
spending. After, inflation will fall and aggregate demand will be equalized to states productivity.
According to Brown-Collier and Collier (1995), the socialization of investment played the
most important role in Keynesian theory. They point out that economists prescribed to Keynes an
opinion where balance of economy and full employment are followed by public budget deficit
spending. However, Brown-Collier and Collier insist that social investment was a key criteria for
solving full employment problem and stabilizing the economy. Thus, Keynes approved that if
government spending increased for social investment it would adjust private investment which
would also lead for stability in economy. Keynes thought that private investment can not be
controlled or be crowded out by public investment, because in his opinion, insufficient amount of
private investment relatively to savings should be defined by needed amount of social investment
that would be possible at a full employment level of output. Furthermore, Keynes was against to run
budget deficit spending by accumulating less taxes for increasing consumption. Government should
not borrow for investment if it leads to public budget deficit as a result. Only the exceptional mean
was investment for social security contribution. Keynes believed that deficit is a result of decreasing
economic activity in the state and the best way to avoid a deficit was to compensate fluctuations of
private investment by planned changes in public investment. According to the authors, Keynes
disagreed with a belief that consumption should be stimulated by varying income via tax policy. In
his view, public and quasi-public investment plans played a huge role in stability of economy.
Bernheim (1989) maintains that Keynesian theory differs from Neoclassic theory by two main
hypothesis: first hypothesis that a big part of people are treated as myopic or liquidity constrained.
Second hypothesis, there are some unemployed economic resources. In obedience to first
assumption, myopic or liquidity constrained population is highly dependent on current disposable
income and any tax cuts bring essential effect to aggregate demand. National income grows when
human resources of the state are not efficiently employed that creates Keynesian multiplier.
Furthermore, Bernheim proposes some objections to the Keynesian theory. First, although
Keynesian theory is strongly based on statement as unemployed resources, this theory does not fully
explain the existence of unemployment. Second objection is related with fiscal policy. It is said that
not every budget deficit spending, growing aggregate demand, means beneficial for economy and
can be adverse. This statement is built an opinion that budget deficit spending enlarges inflation and
displace private investment. He argues that high inflation forms randomness and uncertainty in the
economy.
In the opinion of Filger (2010), Keynes economic theory asserted that during economic
downturn in the private sector, government can increase its public debt for stopping the rise in
unemployment rate with an eye to impact on economic recession. However, Filger states that
Keynes was for decreasing national debt in the time a country has a relative prosperity. It means that
government, during economic growth, should accumulate enough reserves to preclude large
increase of public debt in the future. It is one of the most substantial statements that was widely
ignored by most of Keynesian economists.
Passing on Neoclassic economic theory, this theory is based on relation of demand and supply
to consumers rational behavior. According to Neoclassic economists, consumer goals are to
maximize its individual satisfaction and decision making depends on utility. Moreover, there is
some differences in views between classic and neoclassic economic theories. For example,
neoclassic economist assert that the costs of any goods and services are not only defined by costs of
used material and labor force, the value has a significant effect on price and demand of goods and
services.
Talking about Neoclassic approach towards budget deficit, it was briefly explained by
Carrasco (1988), where she states that the main reason why Neoclassic economists do not prefer to
run budget deficit is its worse effect on private investment. It is known that if the government
increases its spending it leads to increase of interest rate. When the state has a relatively high
interest rate, private companies start to borrow less and save more. Such actions obviously worsen
economic growth, because private investment can not afford any credits to fund growth and
expansion. These create a situation of lowering taxes and borrowing government even more money.
In her opinion, more public budget deficit spending creates the crowding out effect that increases
interest rate and displaces private sector spending.
Bernheim affirms that consumption is planned by farseeing people during their life cycle. Total
lifetime consumption can be gone up by budget deficit. It means that budget deficit shifts taxes on
the next generation. Increased consumption leads to decrease in savings, if economy is fully
employed. All these grow interest rate that crowds out accumulation of private capital which is not
desirable by most of economists. According his summation, permanent budget deficit will
considerably decrease accumulation of capital, if consumers behave rationally, farsightedly and can
use perfect capital markets, but if consumers are considered as myopic or liquidity constrained, the
impact of increasing budget deficit will not cause any quantitative changes. However, the most
interesting phenomena is that, if budget deficit is temporary, it will not strongly affect the entire
economy of the state. Such conclusion proves that Neoclassic economic theory can not explain the
effect of temporary budget deficit, but the most of empirical knowledge is related with permanent
budget deficit.
The last economic view, which should be reviewed is Ricardian approach towards public
budget deficit. The central idea of Ricardian view of public deficit was completely investigated by
Barro in his paper The Recardian Approach to Budget Deficit (1989). According to this paper,
peoples consumption is defined by present value of their disposable income. Government budget
constraints define the present value of expenditure and revenues. It means that without changes in
government expenditure there will not be any changes in government taxation policies. Therefore,
Barro stated that if government increases its budget deficit and decrease revenues from taxes, it
must enhance the present value of future taxes. In other words, it creates the choice tax now or tax
later and people will tend to increase their savings to cover future taxes. It can be said that budget
deficit and taxes become equivalent and has no effect on aggregate demand of goods. In economy it
is called as Ricardian equivalence. For example, suppose that government increased their budget
deficit spending. After that will follow increase in private savings which does not impact on
national savings because public savings decrease. Since national savings do not vary, interest rate
should not grow to balance national savings and investment demand. Hence, budget deficit does not
affect investment, public debt and current account deficit, thus private savings are sufficiently
accumulated to not borrow from foreign institutions.
To sum up, it should be said that given economic theories differently treat the effect of budget
deficit on economic growth. Keynesian theory claims that increase of budget deficit in some
circumstances will positively affect economy and brings prosperity in the future. Opposite opinion
is supported by Neoclassic school of thoughts. According to Neoclassic theory, running public
budget deficit leads to higher interest rate that crowd out private investment and consequently
worsen economy. The Ricardian theory excludes any influence of budget deficit spending on
economic changes. By using Ricardian equivalence, supporters claim that any budget deficit
increase will also increase peoples wishes to save money, which will not change national savings
amount. Therefore, reviewing correlation between budget deficit and economic growth, it is
difficult to explain which theory can be more implemented and which is not. In my opinion, all of
them are useful for special economic circumstances and it would be a huge mistake to argue that
one of them are not significant to concern.
 EMPIRICAL RESEARCH
III. METHODOLOGY
By assuming the information of reviewed literature, it can be said that the budget deficit
has an impact on economic growth. Although, there are different opinions towards the effect, the
assumption that the budget deficit spending can be a tool for changing economic situation has a
right to be examined. In current paper work, it will be researched EU countries to make a certain
justification about the effect of budget deficit.
In this paper work it will be used 3 models which were investigated by Al-Khedair (1996).
According to his work, the budget deficit was described as a significant microeconomic variable
affecting the entire economy of tested 7 countries (Japan, Canada, the US, Italy, France, Germany,
the UK). Results showed the effect of budget deficit towards such economic variables as short and
long run interest rates, trade balance and economic growth.
Overall, it will be examined next 3 model, where first two are additional models and the last
one is the most essential model for this paper research. The description of models will be given
below:
1) The budget deficit and interest rate
2) The budget deficit and openness of economy
3) The budget deficit and economic growth

Model 1. The effect of budget deficit on interest rate

According to Al-Khedair, for seeing the impact of budget deficit to interest rate it was applied
next model:
IR = 0 + 1 BDGDP + 2 MS + 3 TBGDP + IRt-1 + u
where, IR is interest rate, BDGDP is budget deficit, MS is money supply, TBGDP is trade
balance and IRt-1 is interest rate lagged one period. As it is seen on this model, Al-Khedair
emphasized to the dependence of interest rate on budget deficit by controlling such economic
variables as money supply and trade balance. Interest rate rises when the government sells public
security. However, if the government finances its budget deficit by seigniorage, it drops interest
rate. Lags in interest rate are essential because interest rate in the previous year can positively or
negatively influence interest rate of next year.
Model 2. The effect of budget deficit on openness of economy
This model has several changes in contrast with previous one:
TBGDP = 0 + 1 BDGDP + 2 NER + 3 MS + 4TT + u
where, TBGDP is trade balance, NER is exchange rate and TT is term of trade. It is given that
the budget deficit increases interest rate for public securities and causes foreign capital inflow.
Thereby, national currency is appreciating comparing to other currencies that badly affects trade
balance of the state. Imports are encouraged by high national currency while export is discouraged.
It results with trade deficit.
Model 3. The effect of budget deficit on economic growth
Last model shows the dependence of economic growth on budget deficit, money supply,
exchange rate, terms of trade and foreign direct investment.
EG = 0 + 1 BDGDP + 2 MS + 3 NER + 4TT + 5FDIGDP + u
where, EG is economic growth and FDIGDP is direct foreign investment. The budget deficit is
a factor which increases economic growth due to a assumption that budget deficit spending
increases employment that enhances economic situation in the state. Other factors are applied as
control variables which are directly related with economic growth.

IV. THE BUDGET DEFICIT ANALYSIS OF EU-28 COUNTRIES

As it was said previously, it will be used panel data for making estimations about the effect of
budget deficit on economic growth of EU-28 countries during 2009-2015. The hypothesis of the
experiment is:
H0: the budget deficit has no impact on the economic growth (interest rate, trade balance)
H1: the budget deficit has a positive and significant impact on the economic growth (interest
rate, trade balance)
Model 1. The effect of budget deficit on interest rate
For evaluating given model it will be used several counties of EU due to a lack of information
about money supply (M3). Taken states are Denmark, Hungary, Poland, Sweden, the Czech
Republic and the UK. Dependent variable is interest rate. Independent variable is budget deficit
(ration of budget revenue to budget deficit). Control variables are money supply (M3) and trade
balance (ratio of export to import)
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.653510 (0.6729) 0.618742 (0.7085) 1.09734 (0.4046)
Money supply (M3) 1.83916* (0.0591) 1.72711 (0.1262) 2.06915*** (0.0005)
Trade balance 3.38851 (0.3144) 2.34919 (0.5419) 0.0594991 (0.9798)
Table 1. The effect of the budget deficit on interest rate
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

Given results shows that budget deficit has no impact on interest rate of given states during
2009-2015. Moreover, all used models shows that variables are not statistically significant and null
hypothesis can not be rejected (p-value is higher than 0.05). Although, it should be noticed that by
using dynamic panel mode it is seen a statistically significant result in money supply, which may
signify that an increase in money supply will decrease interest rate. However, this estimations can
not be treated as a certain proof for making correct decision toward the effect of budget deficit on
interest rate, because there can be a problem of measuring the impact of some economic factors
after a large economic shift. Thus, it should be checked one more time by using lagging indicator of
independent variables.
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 1.06347 (0.5355) 1.39253 (0.4437) 2.01436 (0.2619)
Money supply (M3) 0.992308 (0.3281) 1.09713 (0.3506) 1.10541* (0.0504)
Trade balance 1.17310 (0.6949) 1.47242 (0.6592) 0.875179 (0.7167)
Table 2. The effect of the budget deficit on interest rate with lagging indicator
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

By using lagging indicator, it is not seen any changes comparing to previous table.
Furthermore, in this table it is absent any statistically significant variables which means that interest
rate of investigated states was influenced by other economic factors during last 7 years.
Model 2. The effect of budget deficit on trade balance
In this model, it was necessary to omit variable terms of trade due to a problem of similarity
of the variable to trade balance notion. Not missing such variable creates meaningless model.
Dependent variable is trade balance. Independent variable is budget deficit. Control variables are
real effective exchange rate (adjusted by inflation) and money supply.
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.0725207 (0.4831) 0.0692692 (0.5445) 0.0665544 (0.6381)
Exchange rate 0.124337 (0.1260) 0.101045 (0.2847) 0.0440084 (0.6682)
Money supply (M3) 0.0453338 (0.4588) 0.0352907 (0.6176) 0.082026*** (0.0069)
Table 3. The effect of the budget deficit on trade balance
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

The result of computation shows that budget deficit has no influence on trade balance. P-
values of different model are higher than 0.05 which means that variables are not statistically
significant. Null hypothesis is not rejected and it means that budget deficit of investigated countries
has no impact on trade balance. Though, it is seen a significant effect of money supply on trade
balance with lags. Lets try using the same model with lags for independent variables.
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.207644* (0.0579) 0.168343 (0.1266) 0.193749** (0.0339)
Exchange rate 0.0677243 (0.4116) 0.105443 (0.2623) 0.0844602 (0.2377)
Money supply (M3) 0.0132869 (0.8268) 0.0294309 (0.6667) 0.0241893 (0.6389)
Table 4. The effect of the budget deficit on trade balance with lagging indicator
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

Table 4. indicate that budget deficit with lags for one period becomes more statistically
significant variable and can positively affect trade balance. It means that the effect of budget deficit
on trade balance has not immediate impact but works after some economic shifts.
Model 3. The effect of budget deficit on economic growth
In theoretical framework, it was given a model for exploring the effect of budget deficit on
economic growth as:
EG = 0 + 1 BDGDP + 2 MS + 3 NER + 4TT + 5FDIGDP + u
However, this model should be modified due to incompleteness. In order to improve model
and make more clear conclusions it should be added more control variables and replaced not useful
variables. New model is:
EG = 0 + 1 BDGDP + 2 IR + 3 CPI + 4 OI + 5 GFCF + 5 GEonR&D + u
According to the new model, money supply does not included because there is no annual data
of money aggregates EU-28 countries from 2009-2015. New variables as consumer price index,
openness of economy, gross fixed capital formation and gross expenditure on R&D have a reason to
be used as control variables. The first reason, consumer price index is used instead of inflation rate
which has a direct negative relation with economic growth. Openness of economy indicates the
influence of trade on domestic activities and strength of states economy. Gross fixed capital
formation is used instead of foreign direct investment due to better interpretation of investment of
resident producers with accounting deductions in fixed assets during a given period. Gross
expenditure on R&D is used as good example of human capital indicator contributing to GDP of
any country.
Dependent variable is an economic growth rate which is given as real GDP per capita (EUR
per inhabitant). Independent variable is the budget deficit which is computed as a ration of budget
revenue to budget deficit. Control variables are interest rate , gross fixed capital formation (% of
GDP of the state), gross expenditure on R&D (% of GDP of the state), openness of economy (the
sum of exports and imports divided by GDP) and consumer price index.
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.0124352 (0.6650) 0.000781542 (0.9734) 0.00868 (0.8031)
Interest rate 0.0229291*** 0.00609070 (0.3259) 0.0133078 (0.1106)
(0.0015)
Consumer price index 0.0309916 (0.8550) 0.188646 (0.2520) 0.131852 (0.6166)
Openness index 0.0257442 (0.5951) 0.000956070 0.0737534 (0.3201)
(0.9826)
Capital formation 0.149135*** (1.22e- 0.103890*** (2.59e- 0.00380026 (0.8926)
08) 06)
Expenditure for R&D 0.0216871 (0.3144) 0.0327403 (0.1145) 0.0236951 (0.3883)
Table 5. The effect of the budget deficit on economic growth
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

According to the results of given model, it displays that budget deficit can not make any
instant changes to economic growth. It means that the Keynesian approach which was widely used
in liberal countries during the Great Recession is not applicable by EU states. EU headed the
Neoclassical economic approach where the budget deficit can not be used as a tool for affecting
economic growth by running more deficit spending. Among control variables, the highest impact
comes from capital formation which is statistically significant. Interest rate according to pooled
OSL model has a essential negative effect on economic growth, however pooled OSL model can not
always be a good estimator due to a problem of bias results.
To make more accurate conclusion, it must be checked dynamics of the budget deficit by using
lagging indicator for computing the effect of independent variables in time of economic shifts.

Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.0473686 (0.2172) 0.0310118 (0.3364) 0.0652257 (0.1655)
Interest rate 0.0382742*** 0.0271369*** 0.00321419 (0.6780)
(0.0007) (0.0036)
Consumer price index 0.133109 (0.5573) 0.0984741 (0.6764) 0.299591 (0.4258)
Openness index 0.172139*** (0.0098) 0.292026*** (1.16e- 0.191693*** (0.0003)
05)
Capital formation 0.111613*** (0.0025) 0.0300718 (0.3635) 0.0430910 (0.2844)
Expenditure for R&D 0.0313581 (0.3105) 0.00205356 (0.9467) 0.0459353 (0.3037)
Table 6. The effect of the budget deficit on economic growth with lagging indicator
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

In next table, it is seen some changes in statistical effect of budget deficit to economic growth,
where p-value is becoming smaller. It can denote that budget deficit affects economic growth only
in long-run. However, interest rate and openness index appeared it relevance in economic growth
after applying lags. It means that generally, only investment (capital formation) has instant
influence on economic growth, while such economic variables as interest rate and openness index
reveals its effect after some period.
To prove the evidence of budget deficit impact on economic growth it will be done the last
modeling by using more lags to get more precise justification.
Variables Pooled OSL model Fixed effect model Dynamic panel model
Budget deficit 0.205815*** (0.0014) 0.19649*** (1.55e-07) 0.172126*** (0.0048)
Interest rate 0.00523696 (0.7928) 0.0145317 (0.3494) 0.00384312 (0.8248)
Consumer price index 0.796560 ** (0.0256) 0.401681 (0.2511) 0.370670 (0.4029)
Openness index 0.137837 (0.2303) 0.00900688 (0.9368) 0.0109459 (0.9522)
Capital formation 0.0147722 (0.8064) 0.0287278 (0.3505) 0.0717923 (0.1966)
Expenditure for R&D 0.0349636 (0.5226) 0.00632917 (0.8746) 0.00237042 (0.9618)
Table 7. The effect of the budget deficit on economic growth with a number of lags
Source: Table created by the author, based on the data from Eurostat and OECD database from
2009-2015
Note: Numbers in brackets are p-values of given variables, stars denotes statistical significance of
variables

The last result proves that the budget deficit has an impact on economic growth due to budget
deficit has p-value which lower than 0.05. Null hypothesis is rejected and it is seen a quite precise
evidence of positive effect of budget deficit in long run on economic growth.
CONCLUSION
To conclude the term paper, it must be said that budget deficit will always be a controversial
topic to discuss. According to economic schools, the attitude towards budget deficit differs from one
to another with positive and negative views. If the economic theory says that the budget deficit
poorly affects economic growth, the Keynesian economists provide contrary arguments where
budget deficit plays a huge role in economic prosperity. Although, the United States can be
considered as developed federal state, it can not be ignored that the US has one of the biggest public
debt in the world. However, it is seen from data analysis that European countries have other opinion
and budget deficit is not playing so significant role in their economies.
Throughout data analysis it was proved that interest rate, trade balance and economic growth
are not highly dependent to budget deficit. Budget deficit has no impact in short run to economic
variables and it must be observed that null hypothesis is not rejected. Nevertheless, in long run
budget deficit can affect economic growth where it was observed data with lags, but it is not seen
any effect of budget deficit in long run towards trade balance and interest rate. Generally, it will be
hard to conclude that the budget deficit has not evidence of influence on economic growth, because
even the small evidence of impact can not be rejected.
Overall, the data analysis of EU states resulted with debatable results where in short run budget
deficit has no impact and in long run it would be claimed as statistically significant effect. In my
opinion, the budget deficit can be a good tool for solving such economic issues as economic
recessions, however, it must be viewed that overuse of budget deficit spending ends with
hyperinflation and other negative results. Thus, I state that the budget deficit has a relation with
economic growth, but computing the effect is not always stable.

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Data was collected from Eurostat and OECD databases of EU-28 countries from 2009-2015
Annexes 1
Modeling data in Gretl program
The effect of the budget deficit on interest rate
Annexes 2
The effect of the budget deficit on economic growth with lags
Annexes 3
The effect of the budget deficit on trade balance
Annexes 4
The effect of the budget deficit on trade balance with lags
Annexes 5
The effect of the budget deficit on economic growth
Annexes 6
Annexes 7
The effect of the budget deficit on economic growth with a number of lags