Question

Suppose, the government of Australia incurs a budget deficit of $50 billion due to increased government spending in 2020 as result of Covid 19. Because of this, the government borrowing in 2021 increases by the same amount.

a) Show this development using a graph representing the market for loanable funds for Australia . Explain in writing the effect of this on interest rates.

b) Compare the size of equilibrium changes in 1) investment, 2) public saving, 3) private saving and 4) national saving (public saving + private saving) with $50 billion increase in borrowing. Compare the changes (increase/decrease) in these variables indicating same, less or more than the $50 billion.

c) Will the equilibrium quantity of national savings change by more or less than the initial change in public saving? Explain your answer (in 50 words or less)

Answer 1

(a) We can show the above scenario in a graph as follows:

(b) This deficit results in:

1. Fall in investment: Government's borrowing to finance budget deficit results in reduced supply of loanable funds which was available to finance investment by firms and households. This is known as 'crowding out'.

Budget deficit borrowing crowds out private borrowers who are trying to finance their investments.

It decreases by less than $50 billion.

2. Public Saving decreases : First let's understand what is public saving?

Public saving is the amount of revenue that has been left with the government after paying for its spending.

So, when there is budget deficit government is spending more than its revenue. Thus public saving equally decreases by $50 billion.

3. Increase in Private Saving: Private Saving is the amount that has been left with households after paying for taxes and consumption.

In a closed economy, the private net savings are equal to government deficit.

We can say that government expenses means crediting bank accounts and taking means debiting bank accounts. Thus it increases private savings by more than $50 billion.

4. Reduction in National Saving: National Saving decreases due to budget deficit. National Saving is the total of public and private saving.

It decreases by less than $50 billion and will be equal to investments.

(c) The equilibrium capacity of national saving decreases less than decrease in public saving.

The reason being national saving also involves private savings which increased due to borrowings by government.

The formula for national saving will help us better understand this.

National Saving= Public Saving+ Private Saving

Due to budget deficit, public saving reduced but private saving increased by more than $50 million.