Question

Read the following popular argument in the U.S. political as well as economics circles. “Private saving goes either toward financing the budget deficit or financing investment. It does not take a genius to conclude that reducing the budget deficit leaves no more saving available for investment.” (a) Explain why this statement sounds correct based on the equilibrium condition in the goods market (in a closed economy): investment= private saving+ public saving. What are the policy implications of the statement? (b) Explain and show why the statement is wrong based on IS-LM analysis. What are the policy implications?

Answer 1

a) The goods market equilibrium occurs at a point when the aggregate demand for goods and services, defined as AD = Y^d = C^d + I^d + G₀, is equal to the aggregate supply of goods and services (real GDP), Y.

In other words, the goods market equilibrium condition is

Y^d = Y =C^d + I^d + G₀

This goods market equilibrium can also be expressed in terms of national savings and investment.

By subtracting C^d +G₀ from the left and right hand sides of the equilibrium condition we get:

Y - C^d - G₀ = I^d.

Using the fact that, in equilibrium, national savings is defined as

S^d = Y - C^d - G₀

we get the equivalent equilibrium condition:

S^d = I^d.

Considering the fact that national savings are a sum of private and public savings, the above equation becomes:

Investment = Private Saving + Public Saving

Hence, it is automatically implied that if savings are used to finance budget deficit then there'll be no more savings left to finance the investment in an economy.

b) When the government uses public savings to finance budget deficit, it issues bonds and sells it in the market. The government is able to expand its expenditure with the borrowed money but at the same time it adds to public debt which has both short-run and long run consequences because on this debt the government has not only to pay annually interest on borrowed funds but has to pay back also the principal sum borrowed for which it may levy higher taxes in future. But, it does not necessarily imply that this use of public savings to finance government debt will lead to a decrease in investment.

In the Keynesian model with a fixed price level, the increase in govern­ment expenditure through use of borrowed money causes an upward shift in aggregate expenditure (C + I + G) curve. Thus, the increase in debt-financed government expenditure will bring about expansion in output or income.

With the increase in income at the given tax rate, tax revenue collected will rise which will over time reduce the budget deficit or even ultimately eliminate it so that budget becomes balanced. This can also be illustrated through IS-LM model in Figure 1, where IS and LM curves are drawn, given the money supply in the economy. Y* is the full-employment level of output. Initially, the equilibrium is at income level Y₀.

Now, with debt-financed increase in government expenditure IS curve shift to the right from IS₀ to IS₁, with LM curve remaining the same. As a result, as will be seen from figure, national income increases to Y₁. This will bring about increase in tax revenue collected by the government and over time budget deficit will be eliminated without affecting the level of investment in an economy.