GOVERNMENT BUDGET DEFICITS

When we first discussed the supply and demand for loanable funds earlier in the
book, we examined the effects of government budget deficits, which occur when
government spending exceeds government revenue. Because a government budget
deficit represents negative public saving, it reduces national saving (the sum of
public and private saving). Thus, a government budget deficit reduces the supply
of loanable funds, drives up the interest rate, and crowds out investment.
Now lets consider the effects of a budget deficit in an open economy. First,
which curve in our model shifts? As in a closed economy, the initial impact of the
budget deficit is on national saving and, therefore, on the supply curve for loanable
funds. Second, which way does this supply curve shift? Again as in a closed
economy, a budget deficit represents negative public saving, so it reduces national
saving and shifts the supply curve for loanable funds to the left. This is shown as
the shift from S1 to S2 in panel (a) of Figure 18-5.
Our third and final step is to compare the old and new equilibria. Panel (a)
shows the impact of a U.S. budget deficit on the U.S. market for loanable funds.
With fewer funds available for borrowers in U.S. financial markets, the interest
rate rises from r1 to r2 to balance supply and demand. Faced with a higher interest
rate, borrowers in the market for loanable funds choose to borrow less. This
change is represented in the figure as the movement from point Ato point B along
the demand curve for loanable funds. In particular, households and firms reduce
their purchases of capital goods. As in a closed economy, budget deficits crowd out
domestic investment.
In an open economy, however, the reduced supply of loanable funds has additional
effects. Panel (b) shows that the increase in the interest rate from r1 to r2 reduces
net foreign investment. [This fall in net foreign investment is also part of the
decrease in the quantity of loanable funds demanded in the movement from point
A to point B in panel (a).] Because saving kept at home now earns higher rates of
return, investing abroad is less attractive, and domestic residents buy fewer foreign
assets. Higher interest rates also attract foreign investors, who want to earn
the higher returns on U.S. assets. Thus, when budget deficits raise interest rates,
both domestic and foreign behavior cause U.S. net foreign investment to fall.
Panel (c) shows how budget deficits affect the market for foreign-currency exchange.
Because net foreign investment is reduced, people need less foreign currency
to buy foreign assets, and this induces a leftward shift in the supply curve
for dollars from S1 to S2. The reduced supply of dollars causes the real exchange
rate to appreciate from E1 to E2. That is, the dollar becomes more valuable compared
to foreign currencies. This appreciation, in turn, makes U.S. goods more expensive
compared to foreign goods. Because people both at home and abroad
switch their purchases away from the more expensive U.S. goods, exports from the
United States fall, and imports into the United States rise. For both reasons, U.S.
net exports fall. Hence, in an open economy, government budget deficits raise real interest
rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade
balance toward deficit.

THE EFFECTS OF A GOVERNMENT BUDGET DEFICIT. When the government runs a

budget deficit, it reduces the supply of loanable funds from S1 to S2 in panel (a). The interest rate
rises from r1 to r2 to balance the supply and demand for loanable funds. In panel (b), the
higher interest rate reduces net foreign investment. Reduced net foreign investment, in
turn, reduces the supply of dollars in the market for foreign-currency exchange from S1 to
S2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate
from E1 to E2. The appreciation of the exchange rate pushes the trade balance toward
deficit.
An important example of this lesson occurred in the United States in the 1980s.
Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of the U.S. federal
government changed dramatically. The president and Congress enacted large cuts in taxes, but
they did not cut government spending by nearly as much, so the result was a large budget deficit.
Our model of the open economy predicts that such a policy should lead to a trade deficit, and in
fact it did, as we saw in a case study in the preceding chapter. The budget deficit and trade deficit
during this period were so closely related in both theory and practice that they earned the
nickname the twin deficits.We should not, however, view these twins as identical, for many
factors beyond fiscal policy can influence the trade deficit.

GOVERNMENT BUDGET DEFICITS AND SURPLUSES

We can analyze the effects of a budget deficit by following our three steps in
the market for loanable funds, which is illustrated in Figure 13-4. First, which
curve shifts when the budget deficit rises? Recall that national savingthe source
of the supply of loanable fundsis composed of private saving and public saving.
A change in the government budget deficit represents a change in public saving
and, thereby, in the supply of loanable funds. Because 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 loanable 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 loanable funds available to finance investment by households and firms.
Thus, a budget deficit shifts the supply curve for loanable funds to the left from
S1 to S2, as shown in Figure 13-4.
Third, we can compare the old and new equilibria. In the figure, when the
budget deficit reduces the supply of loanable 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 loanable 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 loanable 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 loanable 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 economys 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
loanable funds, reduces the interest rate, and stimulates investment. Higher investment,
in turn, means greater capital accumulation and more rapid economic growth.

POLICY 1: TAXES AND SAVING

billion to $1,600 billion. That is, the shift in the supply curve moves the market
equilibrium along the demand curve. With a lower cost of borrowing, households
and firms are motivated to borrow more to finance greater investment. Thus, if a
change in the tax laws encouraged greater saving, the result would be lower interest rates
and greater investment.
Although this analysis of the effects of increased saving is widely accepted
among economists, there is less consensus about what kinds of tax changes should
be enacted. Many economists endorse tax reform aimed at increasing saving in order
to stimulate investment and growth. Yet others are skeptical that these tax
changes would have much effect on national saving. These skeptics also doubt the
equity of the proposed reforms. They argue that, in many cases, the benefits of the
tax changes would accrue primarily to the wealthy, who are least in need of tax relief.
We examine this debate more fully in the final chapter of this book.

POLICY 2: TAXES AND INVESTMENT

Second, which way would the demand curve shift? Because firms would have
an incentive to increase investment at any interest rate, the quantity of loanable
funds demanded would be higher at any given interest rate. Thus, the demand
curve for loanable funds would move to the right, as shown by the shift from D1 to
D2 in the figure.
Third, consider how the equilibrium would change. In Figure 13-3, the increased
demand for loanable funds raises the interest rate from 5 percent to 6 percent,
and the higher interest rate in turn increases the quantity of loanable funds
supplied from $1,200 billion to $1,400 billion, as households respond by increasing
the amount they save. This change in household behavior is represented here as a
movement along the supply curve. Thus, if a change in the tax laws encouraged
greater investment, the result would be higher interest rates and greater saving