How Government Borrowing Affects Investment and the Trade Balance *

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1 OpenStax-CNX module: m How Government Borrowing Affects Investment and the Trade Balance * OpenStax This work is produced by OpenStax-CNX and licensed under the Creative Commons Attribution License 4.0 By the end of this section, you will be able to: Abstract Explain the national saving and investment identity in terms of demand and supply Evaluate the role of budget surpluses and trade surpluses in national saving and investment identity When governments are borrowers in nancial markets, there are three possible sources for the funds from a macroeconomic point of view: (1) households might save more; (2) private rms might borrow less; and (3) the additional funds for government borrowing might come from outside the country, from foreign nancial investors. Let's begin with a review of why one of these three options must occur, and then explore how interest rates and exchange rates adjust to these connections. 1 The National Saving and Investment Identity The national saving and investment identity, rst introduced in The International Trade and Capital Flows chapter, provides a framework for showing the relationships between the sources of demand and supply in nancial capital markets. The identity begins with a statement that must always hold true: the quantity of nancial capital supplied in the market must equal the quantity of nancial capital demanded. The U.S. economy has two main sources for nancial capital: private savings from inside the U.S. economy and public savings. Total savings = Private savings (S) + Public savings (T G) (1) These include the inow of foreign nancial capital from abroad. The inow of savings from abroad is, by denition, equal to the trade decit, as explained in The International Trade and Capital Flows chapter. So this inow of foreign investment capital can be written as imports (M) minus exports (X). There are also two main sources of demand for nancial capital: private sector investment (I) and government borrowing. * Version 1.10: Feb 7, :26 pm

2 OpenStax-CNX module: m Government borrowing in any given year is equal to the budget decit, and can be written as the dierence between government spending (G) and net taxes (T). Let's call this equation 1. Private savings + Inow of foreign savings = Private investment + Government budget decit S + (M X) = I + (G T) Governments often spend more than they receive in taxes and, therefore, public savings (T G) is negative. This causes a need to borrow money in the amount of (G T) instead of adding to the nation's savings. If this is the case, governments can be viewed as demanders of nancial capital instead of suppliers. So, in algebraic terms, the national savings and investment identity can be rewritten like this: Private investment = Private savings + Public savings + Trade decit I = S + (T G) + (M X) Let's call this equation 2. A change in any part of the national saving and investment identity must be accompanied by osetting changes in at least one other part of the equation because the equality of quantity supplied and quantity demanded is always assumed to hold. If the government budget decit changes, then either private saving or investment or the trade balanceor some combination of the threemust change as well. Figure 3 (Eects of Change in Budget Surplus or Decit on Investment, Savings, and The Trade Balance ) shows the possible eects. (2) (3) Eects of Change in Budget Surplus or Decit on Investment, Savings, and The Trade Balance Figure 3: Chart (a) shows the potential results when the budget decit rises (or budget surplus falls). Chart (b) shows the potential results when the budget decit falls (or budget surplus rises). 2 What about Budget Surpluses and Trade Surpluses? The national saving and investment identity must always hold true because, by denition, the quantity supplied and quantity demanded in the nancial capital market must always be equal. However, the formula will look somewhat dierent if the government budget is in decit rather than surplus or if the balance of trade is in surplus rather than decit. For example, in 1999 and 2000, the U.S. government had budget

3 OpenStax-CNX module: m surpluses, although the economy was still experiencing trade decits. When the government was running budget surpluses, it was acting as a saver rather than a borrower, and supplying rather than demanding nancial capital. As a result, the national saving and investment identity during this time would be more properly written: Private savings + Trade decit + Government surplus = Private investment S + (M X) + (T G) = I (4) Let's call this equation 3. Notice that this expression is mathematically the same as equation 2 except the savings and investment sides of the identity have simply ipped sides. During the 1960s, the U.S. government was often running a budget decit, but the economy was typically running trade surpluses. Since a trade surplus means that an economy is experiencing a net outow of nancial capital, the national saving and investment identity would be written: Private savings (5) = Private investment + Outow of foreign savings + Government budget decits = I + (X M) + (G T) Instead of the balance of trade representing part of the supply of nancial capital, which occurs with a trade decit, a trade surplus represents an outow of nancial capital leaving the domestic economy and being invested elsewhere in the world. demandprivate (6) savings = Private investment + Government budget decit + Trade surpluss = I + (G T) + (X M) The point to this parade of equations is that the national saving and investment identity is assumed to always hold. So when you write these relationships, it is important to engage your brain and think about what is on the supply side and what is on the demand side of the nancial capital market before you put pencil to paper. As can be seen in Figure 6 (United States On-Budget, Surplus, and Decit, ($ millions) ), the Oce of Management and Budget shows that the United States has consistently run budget decits since 1977, with the exception of 1999 and What is alarming is the dramatic increase in budget decits that has occurred since 2008, which in part reects declining tax revenues and increased safety net expenditures due to the Great Recession. (Recall that T is net taxes. When the government must transfer funds back to individuals for safety net expenditures like Social Security and unemployment benets, budget decits rise.) These decits have implications for the future health of the U.S. economy.

4 OpenStax-CNX module: m United States On-Budget, Surplus, and Decit, ($ millions) Figure 6: The United States has run a budget decit for over 30 years, with the exception of 1999 and Military expenditures, entitlement programs, and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major contributors to the dramatic increases in the decit after (Source: Table 1.1, "Summary of Receipts, Outlays, and Surpluses or Decits," A rising budget decit may result in a fall in domestic investment, a rise in private savings, or a rise in the trade decit. The following modules discuss each of these possible eects in more detail. 3 Key Concepts and Summary A change in any part of the national saving and investment identity suggests that if the government budget decit changes, then either private savings, private investment in physical capital, or the trade balanceor some combination of the threemust change as well. 4 Self-Check Questions Exercise 1 (Solution on p. 6.) In a country, private savings equals 600, the government budget surplus equals 200, and the trade surplus equals 100. What is the level of private investment in this economy?

5 OpenStax-CNX module: m Exercise 2 (Solution on p. 6.) Assume an economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000. a. Write out a national saving and investment identity for this economy. b. What will be the balance of trade in this economy? c. If the budget surplus changes to a budget decit of 1000, with private saving and investment unchanged, what is the new balance of trade in this economy? 5 Review Questions Exercise 3 Based on the national saving and investment identity, what are the three ways the macroeconomy might react to greater government budget decits? Exercise 4 How would you expect larger budget decits to aect private sector investment in physical capital? Why? 6 Critical Thinking Questions Exercise 5 Assume there is no discretionary increase in government spending. Explain how an improving economy will aect the budget balance and, in turn, investment and the trade balance. Exercise 6 Explain how decreased domestic investments that occur due to a budget decit will aect future economic growth. Exercise 7 The U.S. government has shut down a number of times in recent history. Explain how a government shutdown will aect the variables in the national investment and savings identity. Could the shutdown aect the government budget decit?

6 OpenStax-CNX module: m Solutions to Exercises in this Module Solution to Exercise (p. 4) We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of nancial capital. Then: S + (T G) = I + (X M) = I I = 700 (7) Solution to Exercise (p. 5) a. Since the government has a budget surplus, the government budget term appears with the supply of capital. The following shows the national savings and investment identity for this economy. S + (T G) = I + (X M) (8) b. Plugging the given values into the identity shown in part (a), we nd that (X M) = 0. c. Since the government has a budget decit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade decit or a trade surplus. But when you see that the quantity demanded of nancial capital exceeds the quantity supplied, you know that there must be an additional quantity of nancial capital supplied by foreign investors, which means a trade decit of This example shows that in this case there is a higher budget decit, and a higher trade decit. S + (M X) = I + (G T) = (9)