THE IMPACT OF GOVERNMENT DEFICITS WHEN CREDIT MARKETS ARE IMPERFECT -EVIDENCE FROM THE INTERWAR PERIOD

A counterfactual assumption underlying Ricardian and Neoclassical appr oaches to the rote of deficits is that credit markets are perfect. Whi le it is frequently asserted that the Ricardian neutrality result is i nvalidated by credit market imperfections, the theoretical literature suggests that this is ultimately an empirical question. However, almos t no empirical evidence has been presented. This paper uses vector aut oregressive models of the interwar macroeconomy to evaluate the role o f 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.