The Impacts of Government
Borrowing
1. Government Borrowing Affects
Investment
and the Trade Balance
The Macroeconomics of Saving
and Investment
The quantity of financial capital supplied in the
market must equal the quantity of financial
capital demanded.
Two Main Sources for Financial Capital
1. Private saving (SPrivate) is equal to what households
retain of their earned income (S) and inflow of foreign
financial capital (X - M)
SPrivate = S + X − M
2. Public saving (SPublic) equals the amount of tax
revenue (T) the government retains after paying for
government purchases (G):
SPublic = T − G
When G > T, SPublic is equal is negative, making the
government a demander of financial capital so:
STotal = S + (M − X)
Two Main Sources of Demand for Financial Capital
1. Private sector investment (I)
2. Government borrowing which equals the difference
between government spending (G) and net tax revenues
(T):
Private Investment = I + (G – T)
National Savings and Investment Identity
Private Investment = I + (G – T)
Total Savings = S + (M − X)
S + (M − X) = I + (G − T)
Then,
I = S + (T − G) + (M – X)
If the budget deficit changes
then private savings, investment, or the trade balance
must change.
Potential Results of a Budget Deficit
Chart (a) shows the potential results when the
budget deficit rises (or budget surplus falls).
Chart (b) shows the potential results when the
budget deficit falls (or budget surplus rises).
1. In a country, private savings equals 600, the
government budget surplus equals 200, and the
trade surplus equals 100. What is the level of
private investment in this economy?
S + (M − X) = I + (G − T ) but with surpluses,
S + (T − G) = I + (X − M )
600 + 200 = I + 100
800 = I + 100
I = 700
1.Assume an economy has a budget surplus of
1,000, private savings of 4,000, and
investment of 5,000.
a. Write out an national savings and
investment identity for this economy.
Since the government has a budget surplus, the government budget
term appears with the supply of capital (again).
S + (T − G) = I + (X − M )
1.Assume an economy has a budget surplus of
1,000, private savings of 4,000, and
investment of 5,000.
b. What will be the balance of trade in this
economy?
S + (T − G) = I + (X − M )
4,000 + 1,000 = 5,000 + (X – M)
(X – M) = 0
1.Assume an economy has a budget surplus of
1,000, private savings of 4,000, and
investment of 5,000.
c. If the budget surplus changes to a budget
deficit of 1000, with private savings and investment
unchanged, what is the new balance of trade in this
economy?
With a budget deficit, the government budget term
appears with the demand for capital.
S + (M − X) = I + (G − T )
4,000 + (M – X) = 5,000 + 1,000
(M – X) = 2,000
Showing a higher budget deficit and a higher trade deficit.
Annual Deficits
T is net taxes, so when the government must
transfer funds back to individuals for safety net
expenditures like Social Security and
unemployment benefits, budget deficits rise.
Market for loanable funds The interaction of borrowers
and lenders that determines the market interest rate and
the quantity of loanable funds exchanged.
Demand and Supply in
the Loanable Funds
Market
Demand is determined
by the willingness of
firms to borrow money
to engage in new
investment projects.
Supply is determined by the willingness of
household savings or government saving or dissaving.
Demand and Supply in
the Loanable Funds
Market
Equilibrium determines the real interest rate
and the quantity of loanable funds exchanged.
Demand and Supply in
the Loanable Funds
Market
Movements in Saving, Investment, and Interest Rates
An Increase in the Demand for Loanable Funds
An increase in demand increases
the equilibrium interest rate
from i1 to i2,
and it increases the equilibrium
quantity of loanable funds from
L1 to L2.
Saving and investment both
increase.
The Effect of a Budget Deficit
When the government
begins running a budget
deficit, the supply of
loanable funds shifts to
the left.
The equilibrium interest
rate increases from i1 to
i2,
the equilibrium quantity
of loanable funds falls
from L1 to L2.
As a result, saving and
investment both decline.
Crowding out A decline in private expenditures as a result of an increase
in government purchases.
Crowding Out
A decline in private
expenditures as a
result of an increase
in government
purchases.
Interest rates rise.
Fewer investments
remain profitable
The "crowding out" of private investment due to
government borrowing to finance expenditures appears to
have been suspended during the Great Recession.
Long-run economic growth The process by which rising
productivity increases the average standard of living.
Best measured by real GDP per person, which is usually
referred to as real GDP per capita.
Measured in
2005 dollars,
real GDP per
capita in the
United States
grew from about
$5,600 in 1900
to about
$42,200 in
2010.
The Growth in Real
GDP per Capita,
1900–2010
What Determines the Rate of LongRun Growth?
1. Labor productivity The quantity of goods and
services that can be produced by one worker or by one
hour of work.
2. Increases in Capital per Hour Worked
As the physical capital stock per hour worked
increases, worker productivity increases.
Increases in human capital are particularly important in
stimulating economic growth.
3. Technological Change More important than
increases in capital per hour worked.
Public Investment in Physical Capital
Types of Physical Capital
Federal Outlays (2011)
Transportation
$59,920 billion
Community and regional development
$10,544 billion
Natural resources and the
environment
$6,741 billion
Education, training, employment, and
social services
$71 billion
Other
$8,427 billion
Total
$85,703 billion
Public physical capital investment of this sort
can increase the output and productivity of
the economy.
Public Investment in Human Capital
A highly educated and skilled workforce
contributes to a higher rate of economic
growth.
Public Investment on Technology
Fiscal policy can encourage R&D using either
direct spending or tax policy.
Government could spend more on the R&D
that is carried out in government
laboratories, as well as expanding federal
R&D grants to universities and colleges,
nonprofit organizations, and the private
sector.
Public Investment Summary
Physical
Capital
Human
Capital
New Technology
Private
Sector
New investment On-the-job
in property and training
equipment
Research and development
Public
Sector
Public
infrastructure
Research and development
encouraged through
private sector incentives and direct
spending.
Public
education
Job
training
The effects of many growth-oriented policies will
be seen very gradually over time, as students are
better educated, physical capital investments are
made, and new technologies are invented and
implemented.
Price
Level
SRAS1
G
H
G
P1
AD1
Y1
AD2
Goods & Services
(real GDP)
• Government deficit would shift AD1 to AD2.
• Household saving keeps demand unchanged at AD1.
Loanable Funds
Market
Real
interest
rate
S1
S2
e1
no effect on the interest
rate, real GDP,
and unemployment.
e2
r1
D1
Q1
Q2
D2
Quantity of
loanable funds
1. Government borrows from the loanable funds
market, increasing the demand (to D2).
2. People save for expected higher future taxes
(raising the supply of loanable funds to S2.)
3. Loans increase, but interest rate doesn’t.
Potential GDP The level of real GDP attained when all
firms are producing at capacity.
Potential GDP increases
as the labor force and
the capital stock grow
and technological change
occurs.
The smooth red line
represents potential
GDP,
and the blue line
represents actual real
GDP.
During recessions actual
real GDP is been less
than potential GDP.
Actual and
Potential GDP
The
Circular
Flow
The Financial System
Financial markets Markets where financial securities,
such as stocks and bonds, are bought and sold.
A financial security is a document—sometimes in
electronic form—that states the terms under which
funds pass from the buyer of the security—who is
providing funds—to the seller.
Stocks are financial securities that represent partial
ownership of a firm.
Bonds are financial securities that represent promises
to repay a fixed amount of funds.
1. In the national savings and investment identity
framework, an inflow of savings from abroad is, by
definition, equal to:
A. private sector investment.
B. the trade surplus.
C. the trade deficit.
D. domestic household savings.
2. When governments are borrowers in financial capital
markets, which of the following is least likely to be a
possible source of the funds from a macroeconomic point
of view?
A.
B.
C.
D.
central bank prints more money
increase in household savings
decrease in borrowing by private firms
foreign financial investors
3. The US economy has two main sources for financial
capital:
A. private savings from U.S. households and firms;
inflows of foreign financial investment.
B. private sector investment; government borrowing.
C. private savings from US households and firms;
government borrowing..
D. private sector investment; inflows of foreign
financial investment from abroad.
4. Which is one economic mechanism by which government
borrowing can crowd out private investment?
A.
B.
C.
D.
deficit decrease
smaller trade surplus
larger trade surplus
higher interest rate