Question

8. Suppose the government borrows $20 billion more next year than this year. a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall? b. What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing. c. How does the elasticity of supply of loanable funds affect the size of these changes? d. How does the elasticity of demand for loanable funds affect the size of these changes? e. Suppose households believe that greater govern- ment borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?

Answer 1

a) If the government borrowing increases then there will be a lesser level of loanable funds in the market for private borrowing.
This is known as 'crowding out' effect and this will cause a rise in the interest rates. The supply curve will shift towards left and interest rates will rise.

b) The rise in interest rate will raise the cost of capital and borrowing will become costly and that will depress the investment.
However, the rise in interest rates means saving will be attractive and that will lead to a higher level of saving in the economy.
The magnitude of rising in interest rate will depend upon the loanable funds available in the economy as well as the earlier level of government borrowing. If the $20 billion rise is proportionately higher to the earlier level then it will affect interest rates to a higher extent. The increase in interest rate will then incentivize saving and disincentivize borrowing.
Public savings will be negative if there is a deficit. national saving will depend upon the magnitude of rise in private saving and a decrease in public saving.

Interest Rate r2 r1 Loanable Funds f1 f2

c) The supply of loanable funds tends to be higher at the higher level of the interest rate because supply tends to be upward sloping. So if supply is elastic then the interest rate will change according to the elasticity of supply. The higher elasticity means the interest rate will change by a higher level and that will make saving further attractive.
On the other hand, inelastic supply means the change in the interest rate won't be material.

d) If the elasticity of demand is elastic then a higher level of interest rate means the demand will be lower drastically and investment will affect. If the demand is inelastic then it won't affect demand and investment will not change materially.

e) If the people assume that the higher borrowing now will be compensated by future tax rise then it will force the people to save more as they will try to adjust the future cash outflow by saving more and consumption will be lower further.
This will increase private savings.
The level of investment will be lower as compared to mentioned earlier and savings will be higher.