Suppose the government borrows 20 billion more next year than this year. a. Use a supply-and-de

Suppose the government borrows 20 billion more next year...

Key Concepts

Loanable Funds Market

The loanable funds market is a conceptual framework used to analyze the interaction between savers and borrowers. In this market, the supply of funds typically comes from household savings, while the demand comes from entities that require funds for investment and government borrowing. This model helps explain how interest rates are determined by the intersection of the supply and demand curves for funds, and how shifts in either can affect the overall allocation of resources in an economy.

Interest Rate Determination

Interest rate determination is central to the loanable funds market, as it represents the equilibrium price at which borrowing equals saving. When there is an increase in demand for funds, such as through additional government borrowing, the equilibrium interest rate tends to rise. This higher interest rate then influences various economic activities, including private investment and savings behavior.

Government Borrowing and Crowding Out

Government borrowing affects the loanable funds market by increasing the demand for funds. This can lead to a 'crowding out' effect, where higher interest rates discourage private investment by raising the cost of borrowing for businesses and households. The crowding out effect highlights the trade-off between public and private sector borrowing and its potential impact on economic growth.

Elasticity of Loanable Funds Supply and Demand

The elasticity of supply and demand in the loanable funds market measures how responsive the quantity of funds supplied or demanded is to changes in the interest rate. A relatively inelastic supply implies that changes in interest rates lead to only small changes in the amount of saving, while an inelastic demand implies that investment is less sensitive to interest rate fluctuations. These elasticities determine the magnitude of changes in interest rates and investment in response to shifts in government borrowing.

Public Saving

Public saving refers to the portion of government revenue that is not spent on public expenditures. It is calculated as the difference between tax receipts and government spending. An increase in government borrowing typically indicates lower public saving, as the government finances a larger portion of its expenditure by borrowing, thereby reducing the overall national saving.

Private and National Saving

Private saving is the saving that households accumulate from their disposable income, and it constitutes a major part of the supply of funds in the loanable funds market. National saving is the sum of private saving and public saving. Changes in government borrowing can affect national saving both directly, by altering public saving, and indirectly, through changes in private saving if households adjust their saving behavior in anticipation of future budgetary changes.

Government Debt Expectations and Ricardian Equivalence

Government debt expectations refer to the beliefs held by households regarding the future implications of current government borrowing, such as higher taxes to repay debt. According to the Ricardian Equivalence hypothesis, if households foresee future tax increases due to current borrowing, they may increase their private saving to offset anticipated future tax burdens. This concept is critical in understanding how fiscal policy and government borrowing decisions can alter saving behavior and affect the overall supply of loanable funds in the present.

Transcript

00:01 Here we're working with the macroeconomic ideas of financial savings, investment, interest rates, and how all of this is intertwined.

00:09 So let's take a look here at an example in which the government chooses to borrow $20 billion more than it did this year.

00:18 To start, let's go ahead and draw the supply and demand curves for this so we can better understand the other effects that take place.

00:25 So we know that supply is always upward sloping.

00:29 So we can give ourselves an upward sloping curve.

00:31 Demand is always downward sloping.

00:33 So we can start here with just really general supply and demand curves.

00:38 Now we're told that they are borrowing an additional $20 billion.

00:42 So that means that the supply of loanable funds would also decrease by that $20 billion.

00:48 So our supply curve is going to shift left.

00:51 So here's our new supply curve.

00:53 Let's denote that as s1.

00:55 And let's go ahead and identify where our equilibriums are at.

00:58 So we see it.

00:59 We have one that exists here.

01:01 So this would be our first equilibrium.

01:04 And here's our new equilibrium.

01:06 We'll make that e1 as well.

01:08 So we initially had the supply of loanable funds equal to l right here.

01:15 And we had an interest rate which sat right in here.

01:20 This was our first interest rate.

01:22 But after the government reduces their loanable funds by $20 billion because they chose to borrow $20 billion additional, it's shifted over in this direction.

01:32 So we now have a new loanable funds equal to l1 right here.

01:36 Our interest rate has gone up to i1.

01:41 And you can see that right here, this is where our loanable funds minus 20 would sit.

01:47 All right.

01:50 So now that we've drawn this, we can answer the question of exactly what happened to our interest rate.

01:55 And as you can see it increased right here.

01:59 So now, also with this graph we've just drawn, we can start to answer the questions of what change took place in investment, private and public saving, and national saving.

02:09 What we want to do first is recall what i have written in blue, and that's that national saving is equal to public saving plus private saving.

02:16 Thus, national saving is also equal to investment.

02:20 So taking a look here, we can see that because of the increase in government borrowing, national savings would have fallen by less than $20 billion, because you can see right in here that between l minus 20 and l, that was our $20 billion change.

02:39 But our new equilibrium sits somewhere in the middle at l1.

02:43 So it wasn't quite as great as that.

02:45 So we can see that national saving, right here, this decreased by less than 20.

02:57 20 billion, that is.

02:58 I'm just going to write 20.

03:00 And because of that, we can see that since national saving is equal to investment, that means that investment also declined by less than 20.

03:18 All right.

03:19 So now we want to take a look at our public savings right here.

03:23 And we know that government borrowing is equal to public borrowing...