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. .

Answer Graph

Effect on interest rate (1 mark)

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.

Answer:

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:

Answer 1

a. As the government incurs a budget deficit, it will be unable to save money and increase in government borrowing will reduce the level of public savings of the government. As the level of public savings of the government decreases, the national savings or supply of loanable funds will decrease. This decrease in the supply of loanable funds in the market will shift the SS curve leftwards to S'S' and thus new equilibrium shifts from point E1 to point E2 where the level of interest rate in the loanable funds market will increase.This is depicted below:

Thus, increase in government spending leads to increase in the rate of interest in loanable funds market.

b. 1.Investment : Increase in the rate of interest will reduce the level of investment in the economy and cause a movement from point E1 to point E2 on demand curve leading to decrease in investment by less than $50 million.

2. Public Savings: Budget Deficit in the economy will reduce the amount of public savings or savings of the government by the same amount as deficit = $50 billion.

3. Private Savings: Increase in the rate of interest will increase return on savings of private individuals and as their return increases, the amount of private savings will increase but by less than the amount of $50 billion.

4. National Savings: Due to decline in public savings being greater than increase in private savings, thus overall amount of National Savings will decrease in the economy.

c. As the diagram depicts, the initial change in the level of public savings is a decrease of $50 billion. But at the equilibrium level, it can be observed that equilibrium quantity of national savings has decreased by less than $50 billion because of increase in the rate of interest caused by increased government borrowing and this increase in the rate of interest also increases the level of private savings in the economy because returns on private savings will increase.