Question

suppose the government borrows $20 billion more next year than this year.
use a demand and supply digram to analyze this policy. does the intrest increases or fall?

Answer 1

(a) An increase in government borrowing by $20 billion affects the demand – supply curves in the following diagram.

The intersection of the original demand curve D and supply curve S for loanable funds determine the equilibrium interest rate i. When government borrows $20 billion, supply of loanable funds is reduced by the same amount and thus shifts towards the left from S to S₁. With demand remaining unchanged, the original demand curve intersects the new supply curve at e₁; as a result the interest rate increases from i to i₁. So increase in government borrowing increases the interest rate.

(b) To recall

National saving = public saving + private saving

National saving = Investment

It is clear from the above diagram that the initial national saving is L which falls to L₁ due to increase in government borrowing. So, national savings fall by less than $20 billion. Since national savings is equal to investment, investment also declines by less than $20 billion. Now the increased government borrowing refers to public borrowing; so public saving declines by exactly $20 billion. Since private saving is the difference between national savings and public savings, private saving increases by less than $20 billion.

(c) Elasticity of supply of loanable funds affects the size of above parameters. If supply of loanable funds is more elastic, the supply curve for the loanable funds will be more flat curve. When government borrowing increases, a flat supply curve will increase interest rate by fewer amounts and the national savings would fall by less. If the supply curve is less elastic, the interest rate will increase by a greater amount.

(d) Elasticity of demand for loanable funds will also affect the size of above parameters. If demand for loanable funds is more elastic, the demand curve for the loanable funds will be more flat curve. When government borrowing increases, a flat demand curve will increase interest rate by fewer amounts; but reduces the national savings by more amounts. If the demand curve is less elastic, the interest rate will increase by a greater amount.

(e) The belief that today’s government borrowing implies higher tax payments to pay off the government debt in the future leads to increased private savings. People are motivated to save more for excess tax payments in future. As a result, the supply of loanable funds will increase. Increase in private savings will offset the reduction in public savings; also reduces the amount by which national savings decline; also reduces the amount by which interest rate increases.