Poucv 3: GOVERNMENT BUDGET DEFICITS AND SURPLUSES

A perpetual topic of political debate is the’status of the government budget. Recall that a budget deficit is an excess of government spending over tax revenue. Governments finance budget deficits by borrowing in the bond market, and the accumulation of past government borrowing is called the government debt. A budget surplus, an excess ‘of tax revenue over government spending, can be used to repay some of the government debt. If government spending exactly equals tax revenue! the government is said to have a balanced budget.

Imagine that the government starts will? a balanced budget and then, because of a tax cut or a spending increase, starts running a budget deficit. cap analyze’ the effects of the budget deficit by following our three steps in the market for loan able funds, as illustrated in Figure 4: First, which curve shifts when the government’ starts running a budget deficit? Recall that national saving the source of the supply of loan able funds-is composed of private saving and public saving. A change in the government budget balance represents a change in public saving and, thereby, in the supply of loan able the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loan able funds. Second, which way ,does the supply curve shift? When the government runs a budget deficit, public saving is negative, and ‘this reduces national saving. In other words, when the government borrows to finance its budget deficit, it reduces the supply of loan able funds available to finance investment by households and firms. Thus, a budget deficit shifts the supply curve for loan able funds to the left from S, to S2’ as shown in Figure 4.

Figure 4 The Effect of a Government Budget Deficit.

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loan able funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget, deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from 51 to 52′ the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loan able funds saved and invested falls from $1.200 billion to $800 billion.

The Effect of a Government Budget Deficit.

The Effect of a Government Budget Deficit.

Third, we can compare the old and new equilibria In the figure, when the budget deficit educes the supply of loan able funds, the interest rate rises from 5 percent to 6 percent. This higher interest rate then alters the behavior of the households and firms that participate in the loan market. In particular, many demanders of loan able funds are discouraged by the higher interest rate. Fewer families buy new homes, and fewer firms choose to build new factories. The fall in investment because of government borrowing is
called crowding out and is represented in the figure by the movement along the demand curve from a quantity of $1,200 billion in loan able funds to a quantity of $800 billion. That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment

Thus, the most basic lesson about budget deficits follows directly from their effects on the supply and demand for loan able funds: When the government reduces national saving by running a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate. Government budget surpluses work just the opposite as budget deficits. When government collects more in tax revenue than it spends, its saves the difference by retiring some of the outstanding government debt. This budget surplus, or public saving, contributes to national saving. Thus, a budget surplus increases the supply of loan able funds, reduces the interest rate, and stimulates investment. Higher investment, in turn, means greater capital accumulation and more rapid economic growth.

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