Question

In late February, the current administration had planned to spend $2.5 billion to fight the coronavirus. Less than two months later the government signed off on spending almost a thousand times as much: $2.35 trillion. To prevent a major economic crisis, both the Federal Reserve Bank and the U.S. Treasury have injected trillions of dollars as the negative effects of COVID-19 in the US economy grew larger and larger. Explain how this considerable increase in government spending can affect the fiscal budget (budget deficit) and, in turn, the supply of loanable funds and the corresponding level of investment. In order to recover from a particularly large fiscal deficit, many believe that taxes will have to be raised in the coming years in order to fill this 'hole'. Could this in turn further affect the supply of loanable funds and our ability to fund investment and fuel economic growth? Notes: - You must know that the Federal Reserve Bank and the Federal Government are two separate entities. Do not use them interchangeably as you tackle the DQ.

Answer 1

A considerable government spending increased during the pandemic results in budget deficit because the usually channelized funds are being spent at present and a large amount of this spending rapidly marches past the tax revenues the government has been receiving, especially given the status quo of the United States.

Now as the budget deficit increases, the government's savings or surplus is being depleted too. Which means that they can't as freely as they used to before. Therefore the supply of loanable funds takes a hit instantly, and this in fact affects the related businesses and banks.

As far as private investment is occured, crowding out effect occurs due to the increased government spending. What happens is that the government is 'demanding' more loanable funds and as a result the increased interest rates just curbs private investment. Thus we say the private investment is 'crowded out'.

It's true that the economy will rebound to a maximum in the future, but the question here is that whether increase in taxes do any good in the supply of loanable funds? Well, it might not. It's true that the massive budget deficit might be reduced to some extent when the Fed increases tax, but it hardly increases the supply of lonable funds. For this we need to understand where does loanable funds come from: Consumer Savings. When a consumer decides to save, he/she decides to deposit the money in banks in return for interest payment. And that deposited money is what that is given as loans, or in simple loanable funds. At the advent of increased taxes, ceteris paribus, consumers pay the additional tax from their savings and therefore the supply of loanable funds decreases as the savings deplete. Encouraging private investors to use the infrastructure is one of the vital pathways to stimulate economic growth apart from tedious taxation.