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When we first discussed the supply and demand for loanable funds earlier in the
book, we examined the effects of government budget deficits, which occur when
government spending exceeds government revenue. Because a government budget
deficit represents negative public saving, it reduces national saving (the sum of
public and private saving). Thus, a government budget deficit reduces the supply
of loanable funds, drives up the interest rate, and crowds out investment.
Now lets consider the effects of a budget deficit in an open economy. First,
which curve in our model shifts? As in a closed economy, the initial impact of the
budget deficit is on national saving and, therefore, on the supply curve for loanable
funds. Second, which way does this supply curve shift? Again as in a closed
economy, a budget deficit represents negative public saving, so it reduces national
saving and shifts the supply curve for loanable funds to the left. This is shown as
the shift from S1 to S2 in panel (a) of Figure 18-5.
Our third and final step is to compare the old and new equilibria. Panel (a)
shows the impact of a U.S. budget deficit on the U.S. market for loanable funds.
With fewer funds available for borrowers in U.S. financial markets, the interest
rate rises from r1 to r2 to balance supply and demand. Faced with a higher interest
rate, borrowers in the market for loanable funds choose to borrow less. This
change is represented in the figure as the movement from point Ato point B along
the demand curve for loanable funds. In particular, households and firms reduce
their purchases of capital goods. As in a closed economy, budget deficits crowd out
domestic investment.
In an open economy, however, the reduced supply of loanable funds has additional
effects. Panel (b) shows that the increase in the interest rate from r1 to r2 reduces
net foreign investment. [This fall in net foreign investment is also part of the
decrease in the quantity of loanable funds demanded in the movement from point
A to point B in panel (a).] Because saving kept at home now earns higher rates of
return, investing abroad is less attractive, and domestic residents buy fewer foreign
assets. Higher interest rates also attract foreign investors, who want to earn
the higher returns on U.S. assets. Thus, when budget deficits raise interest rates,
both domestic and foreign behavior cause U.S. net foreign investment to fall.
Panel (c) shows how budget deficits affect the market for foreign-currency exchange.
Because net foreign investment is reduced, people need less foreign currency
to buy foreign assets, and this induces a leftward shift in the supply curve
for dollars from S1 to S2. The reduced supply of dollars causes the real exchange
rate to appreciate from E1 to E2. That is, the dollar becomes more valuable compared
to foreign currencies. This appreciation, in turn, makes U.S. goods more expensive
compared to foreign goods. Because people both at home and abroad
switch their purchases away from the more expensive U.S. goods, exports from the
United States fall, and imports into the United States rise. For both reasons, U.S.
net exports fall. Hence, in an open economy, government budget deficits raise real interest
rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade
balance toward deficit.
Thus, the most basic lesson about budget deficits follows directly from their effects
on the supply and demand for loanable funds: When the government reduces
national saving by running a budget deficit, the interest rate rises, and investment falls.
Because investment is important for long-run economic growth, government budget
deficits reduce the economys growth rate.
Government budget surpluses work just the opposite as budget deficits. When
government collects more in tax revenue than it spends, its saves the difference by
retiring some of the outstanding government debt. This budget surplus, or public
saving, contributes to national saving. Thus, a budget surplus increases the supply of
loanable funds, reduces the interest rate, and stimulates investment. Higher investment,
in turn, means greater capital accumulation and more rapid economic growth.