Question

Suppose that in the next federal budget, the government decides to eliminate all (government) purchases that are financed by borrowing because the politicians worry about a budget deficit. What is wrong with this argument? Briefly discuss using the loanable fund market.

Answer 1

The interest rate is the price of the loanable funds in the economy. The loanable funds market is the place where the savers supply loans and demandedrs demand loan for investment. The demand for loanable fund curve is a negatively sloped curve. This indicates the amount of fund the government, foreginers and the firm demands at each given level of interest rate. The demand for loan is thus planned invetsment (Ip) plus NCO (net capital out flow.

The supply of loanable fund curve is a positively sloped curve. This indicates the amount people want to save at each given level of interest rate. The slope of the curve indicates that as interest rate increases the amounts people want to save increases, and vice versa.The budget surplus does not depend on the interest rate. The amount of funds the government puts into bank is independent of level of interest.

As government decided to stop borrowing the demand for loan will fall. This will also increase the budget surplus of the government and hence the supply of loan. Both the fall in demand and rise in supply will decrease the domestic interest rate.

If the interest rate in the loanable funds market is decreases, the domestic market will be an unprofitable place for investment. The foreigners will move their capital out of the economy and there will a net outflow of capital from the loanable funds market. As NCO rises there will be huge trade surplus. because Capital outflow and trade deficit is closely related. This is because net outflow of goods and services and investment must equal to the net outflow of capital and goods and services to foreigners. That is

The rise in trade surplus will decrease the exchange rate of the economy and currency will be devalued. The devaluation will cause the asset value to fall and the investors will lose. To prevent this loss, the investors start selling domestic currency based assets. This increase the supply of domestic currency in the exchange market. This will trigger a speculative attack. The speculative attack occurs when the foreign and domestic financial investors fear a devaluation of the home currency and engage in massive selling of domestic currency backed assets.

Thus the investment will fall in the economy. Demand will be contracted and the economy will slip to deep recession. Thus,  eliminate all (government) purchases that are financed by borrowing will be a economical disaster