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.

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 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)

Two Main Sources of Demand for Financial Capital

Private Investment = I + (G – T)

Then,

S + (M − X) = I + (G − T)

I = S + (T − G) + (M – X)

National Savings and Investment Identity

Total Savings = S + (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,

600 + 200 = I + 100

800 = I + 100

I = 700

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.

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?

4,000 + 1,000 = 5,000 + (X – M)

(X – M) = 0

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.

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?

4,000 + (M – X) = 5,000 + 1,000

(M – X) = 2,000

Showing a higher budget deficit and a higher trade deficit.

S + (M − X) = I + (G − T )

With a budget deficit, the government budget term appears with the demand for capital.

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.

Demand and Supply in the

Loanable Funds MarketDemand is

determined by the willingness of firms to borrow money to engage in new investment projects.

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

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.

Movements in Saving, Investment, and Interest RatesAn 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 DeficitWhen 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 profitableThe "crowding out" of private investment due to

government borrowing to finance expenditures appears to have been suspended during the Great Recession.

The Growth in Real GDP per Capita, 1900–

2010

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.

Best measured by real GDP per person, which is usually referred to as real GDP per capita.

Long-run economic growth The process by which rising productivity increases the average standard of living.

2. Increases in Capital per Hour Worked

3. Technological Change More important than increases in capital per hour worked.

What Determines the Rate of Long-Run Growth?

1. Labor productivity The quantity of goods and services that can be produced by one worker or by one hour of work.

As the physical capital stock per hour worked increases, worker productivity increases.

Increases in human capital are particularly important in stimulating economic growth.

Public Investment in Physical Capital

Public physical capital investment of this sort can increase the output and productivity of the economy.

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 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

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.

Physical Capital

Human Capital

New Technology

Private Sector

New investment in property and equipment

On-the-job training

Research and development

Public Sector

Public infrastructure

Publiceducation Jobtraining

Research and development encouraged throughprivate sector incentives and direct spending.

AD1

PriceLevel

Y1

Goods & Services(real GDP)

SRAS1

P1

• Government deficit would shift AD1 to AD2.• Household saving keeps demand unchanged at AD1.

AD2

GG

GG

HH

Quantity of loanable fundsQ1

S1

Q2

Loanable FundsMarketReal

interestrate

r1

S2

D2

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.

D1

no effect on the interest rate, real GDP, and unemployment.

e1 e2

Actual and Potential GDP

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.

Potential GDP The level of real GDP attained when all firms are producing at capacity.

TheCircular

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. central bank prints more moneyB. increase in household savingsC. decrease in borrowing by private firmsD. 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. deficit decrease

B. smaller trade surplusC. larger trade surplusD. higher interest rate