Question

Based on the national saving and investment identity, explain how each of the following might react to greater government budget deficits. Be sure to consider all possibilities.

a.    Private saving

b.    Investment

c.     Savings by the rest of the world.

Answer 1

a) Private Saving will increase with the government deficit. An increased government deficit will increase the income of the people with an increased income the saving will also increase. Apart from this, a government deficit will increase the interest rates in the economy, this will also encourage the private individuals to increase their saving at a higher interest rate.

b) Increased government deficit will increase the interest rate in the economy and adversely affect the investment. we call this crowding out effect. At a higher rate, the investors will be reluctant to invest as they will need higher profit to meet the increased interest rate gap.

c) World saving will decrease, as the government deficit will increase the interest rates it will attract the word saving to the economy. People will rush to buy the bonds and other securities which can give them a higher return. So they will move their deposit from their home country to the economy where the interest rates are high.

The second factor will increase the world saving, as the income in the local economy will rise with higher government deficit people will demand more and imports will increase. The income of other economies will increase with exports and therefore their saving will increase too. Overall increase or decrease will be the tradeoff between these two factors.