Federal government budget deficits have been a concern of policymakers in recent years. One concern has been what effects these sustained deficits are having on the U.S. economy. Tax cut proponents have claimed that "deficits don't matter," in a phrase attributed to Vice President Cheney, while deficit "hawks" claim that deficits raise interest rates, to the economy's detriment. This is an important question because how effective tax cuts are in stimulating the economy depends on how the rest of the economy adjusts. As this report explains, the adjustment can occur through interest rates, the trade balance, or private saving. This report reviews theoretical and empirical evidence to see what relationship exists between budget deficits and interest rates. Unfortunately, simply observing whether interest rates are higher or lower in the presence of deficits is not a sufficient test of the hypothesis. That is because there are many other factors that are simultaneously affecting interest rates. These include the state of the economy, the saving behavior of individuals and companies, the investment opportunities of business, the state of financial markets, demographics, and the financial relationship between the United States and the rest of the world. In the real world, these factors cannot be held constant, so economists try to "control" for them statistically to separate out the effects of deficits. But controlling for other factors requires a theoretical model that explains and identifies how a deficit and those other factors affect interest rates. Thus, even those who are skeptical of theoretical explanations are dependent on theoretical models to translate the relationship from the empirical evidence. Because so many different models of the economy exist, some models offer positive evidence about the deficit-interest rate relationship while others offer evidence refuting the relationship. Any explanation of the budget deficit-interest rate relationship must first come to grips with an indisputable fact: budget deficits consume real resources. When the government borrows from the public to finance public spending or tax cuts, the resources must come from somewhere. In mainstream theory, the resources come from the nation's pool of saving, which pushes up interest rates for simple supply and demand reasons. This "crowds out" private investment that was competing with government borrowing for the same pool of national saving. But other theories offer different explanations of where the resources come from that do not involve higher interest rates. Fundamentally, the effect of budget deficits on interest rates is only the proximate question that economists and policymakers wish to answer. The ultimate question is where the resources come from to finance a deficit, and what ramifications the use of those resources have for the nation's welfare. A model in which budget deficits do not affect interest rates still has consequences for the nation's welfare. In reviewing the major theories of the budget deficit's effect, this report explores the deficit's effect on both interest rates and the nation's welfare. It begins with the mainstream view, and then explains how other versions differ from that view. In the mainstream economic view, budget deficits expand total spending (aggregate demand), and thereby short-term economic growth. If a budget deficit is the result of higher government spending, the additional government spending expands aggregate spending directly. If a budget deficit is the result of tax cuts, aggregate spending is expanded by an increase in spending by the tax cut's recipients. In an economy operating at full employment, production (aggregate supply) cannot be increased to match the increase in spending because all of the economy's labor and capital resources are already in use. This mismatch between aggregate demand and aggregate supply must be resolved through market adjustment. Market adjustment takes place in four distinct ways, each of which has consequences for interest rates. The greater demand for goods and services pushes up prices, leading to a temporary increase in inflation. Because nominal interest rates are equal to real (inflation-adjusted) interest rates and the expected inflation rate, an increase in inflation (if anticipated) would push up nominal interest rates. If the Federal Reserve's objective is to maintain a stable inflation rate, as most observers believe, it will offset the rise in demand through a contraction in monetary policy. It will increase short-term real interest rates directly, and this will reduce interest-sensitive spending (i.e., private investment and consumer durables). In the market for savings, the demand for savings has increased for two reasons. First, because the government is now competing with private firms for the same pool of national saving to finance its deficit, the government has increased the demand for savings directly, and interest rates rise as a result. Higher interest rates make investment spending less profitable for private firms, and the budget deficit is thus said to have "crowded out" private investment. Second, in response to the greater demand for their goods, firms wish to increase their investment spending in order to increase their supply of goods. Investment demand increases in response to the desire for higher production, and interest rates rise as a result. In the money market, the increase in aggregate spending leads to an increase in money demand. As a result, if monetary policy is left unchanged, interest rates increase since the opportunity cost of holding money is now greater. With higher interest rates, the same supply of money can now be used to purchase more goods and services because people do not hold on to money as long (money velocity increases). As a result of the interaction between these market forces, resources have been shifted toward the government (or tax cut recipients) and away from the saving of the private sector. This has consequences for the economy in the long run. In the long run, economic growth is dependent on increases in private investment, productivity, and the labor force. By identity, private investment equals national saving less the budget deficit (foreign saving will be considered below). Thus, by reducing national saving, budget deficits lead to less private investment. This reduces the size of the economy in the long run, and future standards of living. If the deficit lasts for one year, there would be a one-time reduction in growth. If the deficit lasted for several years, it would reduce growth for the duration of that time. For this reason, economists often describe deficits as placing a burden on future generations. Deficits allow individuals to enjoy more consumption today. But since this higher consumption comes at the expense of lower saving, and hence lower investment, it reduces the size of the economy in the future. Thus, individuals would enjoy lower consumption in the future. Thus far, it has been assumed that the expansion in the budget deficit was taking place in an economy with fully employed resources. Since all of the economy's resources were already in use, for the government to redirect resources to itself or tax cut recipients required a reduction in the resources available to others. This reallocation occurred through higher prices and interest rates, the latter of which "crowded out" private investment and consumer durables. But in an economy with underemployed labor and capital resources as a result of a recession or low growth, the financing of a budget deficit is no longer a zero-sum scenario in which any resources redirected to the government or tax cut recipients must be fully offset by a reduction in the purchasing power of others. That is because the increase in aggregate spending caused by the deficit leads to unemployed resources being brought back into use, generating new aggregate production to match the increase in aggregate spending. This is how expansionary fiscal policy "stimulates" the economy during a recession. In an extremely underemployed economy, enough unused resources are available to match the increase in aggregate spending entirely. The increase in the budget deficit would be "multiplied" by the fact that re-employed workers increase their spending as well, so that the total increase in aggregate spending is larger than the increase in the budget deficit. In this case, the budget deficit would be unlikely to have much of an effect on interest rates and inflation, as long as it were eliminated once the economy returned to full employment. The U.S. economy has not faced this extreme scenario since the Great Depression. In all recessions since the 1930s, including the last one, some underemployed resources have been available to be brought into use in response to an increase in aggregate spending, but not enough so that there would not be any increase in interest rates or prices within the framework of the conventional model. Thus, expansionary fiscal policy would cause some increase in aggregate spending, with larger increases the further the economy is from full employment. It would also cause some increase in interest rates and prices, but less than in a fully employed economy. During the past couple of years, the economy has been close to economists' estimate of full employment, so the effect of deficits on interest rates and prices would be expected to be greater. If prices and markets do not adjust instantaneously and people's expectations do not change instantaneously, even at full employment it may be possible to temporarily bring additional resources into production, thereby generating some transient stimulus from an increase in the budget deficit. In other words, an increase in the deficit is unlikely to ever lead to zero increase in aggregate spending in the very short run. However, a deficit is likely to lead to a much smaller increase in output and larger increase in prices at full employment than in a recession. And after adjustment took place, the economy would return to full employment, with the same higher interest rates and prices as described in the previous section. Economists tend to disfavor attempts to push the economy above full employment in this way, since the inevitable move back down to full employment could result in overshooting in the opposite direction—recession. Thus far, the mainstream model described has used the assumption that the United States is a closed economy, in which trade and capital does not flow between it and the rest of the world. Relaxing this assumption has very important ramifications for interest rates. In a closed economy, the pool of savings available to the government to finance its deficits and the private sector to finance its investment spending is fixed. For that reason, any increase in the demand for that savings must push up interest rates.