Principles of Macroeconomics, Chapter 10 Part 3

Chapter 10 Part 3 Government budget and government saving The government borrows funds from financial markets and also supplies saving. Therefore the government budget affects market equilibrium interest rates and the equilibrium quantity of saving and investment in the economy. Recall that, according to the expenditure approach, real GDP is measured in terms of total expenditure on final goods and services. Following the expenditure approach, therefore, GDP, Y, is the sum of consumption expenditure, C, investment, I, government purchases, G, and net exports, NX. Ignoring the foreign sector, i.e., excluding net exports: Y=C+I+G Recall that, according to the income approach, real GDP can also be measured in terms of the total value of income paid to households for the factors of production they supply. Therefore, real GDP equals total income. There are three things that households can do with their income: consume it, save it, or pay it to the government as net taxes (taxes net of transfer payments). Therefore: Y = C + S + NT Thus, we have: Y=C+I+G and Y = C + S + NT. Therefore, C + I + G = C + S + NT. Because C appears on both sides of this equation, we can subtract C from both sides and simplify the equation to: I + G = S + NT. Now subtract G from both sides of this equation to obtain: I = S + (NT – G). This equation tells us that investment is financed either by private saving, S, or by government saving, NT – G. If NT – G > 0, the government is collecting more tax revenue than it is spending: the government has a budget surplus. If NT – G < 0, the government is spending more than it is collecting in tax revenue: the government has a budget deficit. A government budget surplus If the government has a budget surplus, this means that government saving is positive and therefore adds to private saving. Assume that the government has a budget surplus of $2 trillion, i.e., government saving is $2 trillion. The total supply of saving increases by $2 trillion: Government saving is a constant $2 trillion at each real interest rate, therefore the total saving supply curve, SS, lies $2 trillion to the right of the private saving supply curve, PS. The horizontal distance between the PS and SS curves is $2 trillion. The market clearing equilibrium real interest rate decreases from 5% to 4%. The equilibrium level of saving and investment increases from $6 trillion to $7 trillion. Note that the equilibrium level of saving and investment increases by less than the amount of government saving, i.e., BE1 < AE1. This is because the market clearing equilibrium real interest rate decreases from 5% to 4%, causing the quantity of private saving supplied to decrease as we move down the PS curve from E0 to A. The decrease in the quantity of private saving supplied, from $6 trillion to $5 trillion, partially offsets the $2 trillion of added government saving, but, on net, the equilibrium quantity of saving and investment still increases by $1 trillion. A government budget deficit If the government has a budget deficit, this means that government saving is negative, i.e., the government is dissaving. In this case, total saving equals private saving minus the budget deficit. Assume that the government has a budget deficit of $2 trillion. The total supply of saving decreases by $2 trillion: Government dissaving is a constant $2 trillion at each real interest rate, therefore the total saving supply curve, SS, lies $2 trillion to the left of the private saving supply curve, PS. The horizontal distance between the PS and SS curves is $2 trillion. The market clearing equilibrium real interest rate increases from 5% to 6%. The equilibrium level of saving and investment decreases from $6 trillion to $5 trillion. Note that the equilibrium level of saving and investment decreases by less than the amount of government dissaving, i.e., BE1 < AE1. This is because the market clearing equilibrium real interest rate increases from 5% to 6%, causing the quantity of private saving supplied to increase as we move up the PS curve from E0 to A. The increase in the quantity of private saving supplied, from $6 trillion to $7 trillion, partially offsets the $2 trillion decrease in total saving due to the budget deficit, but, on net, the equilibrium quantity of saving and investment still decreases by $1 trillion. The tendency for a government budget deficit to cause a decrease in total investment is called the crowding-out effect. In our example, when the market clearing equilibrium real interest rate increased from 5% to 6%, the quantity of funds demanded for investment decreased from $6 trillion to $5 trillion. This would be represented as a movement up along the ID curve from E0 to E1. Thus increased government spending that causes a budget deficit comes at the expense of reduced private investment expenditure – the increased government spending “crowds out” private investment spending. The Ricardo-Barro effect Some economists believe, contrary to the crowdingout theory, that a government budget deficit will have no effect on the market equilibrium real interest rate or on the level of investment. According to this view, the public realizes that a budget deficit financed by borrowing will result in a higher level of government debt in the future. The public anticipates that the government will need to raise taxes in the future in order to pay off the debt. Higher taxes in the future mean a decrease in expected future disposable income. Therefore private saving increases. In effect, the Ricardo-Barro effect is based on the idea that the public will prepare for higher future taxes by immediately increasing their saving by an amount equal to the amount of government dissaving. Therefore, at the same time that the total saving supply curve shifts to the left due to the decrease in government saving, private saving supply increases by the same amount and the total saving supply curve shifts back to the right. Overall, the total saving supply curve remains in its initial position and the market clearing equilibrium real interest rate and the equilibrium quantity of saving and investment remain unchanged: The total saving supply curve, SS, shifts to the left due to the government’s budget deficit, i.e., government dissaving, but then immediately shifts back to its initial position due to the increase in private saving. The market clearing equilibrium real interest rate remains at 5% and the equilibrium level of saving and investment remains at $6 trillion.