Principles of Economics - 3e Chapter 31 The Macroeconomic Impacts of Government Borrowing

The Impacts of Government Borrowing FIGURE President Lyndon Johnson President Lyndon Johnson played a pivotal role in higher education ( Credit of Lyndon Johnson in 1970 by Museum Library , Public Domain ) CHAPTER OBJECTIVES In this chapter , you will learn about Government Borrowing Affects Investment and the Trade Balance Fiscal Policy , Investment , and Economic Growth Government Borrowing Affects Private Saving Fiscal Policy and the Trade Balance Introduction to the Impacts of Government Borrowing BRING IT HOME Financing Higher Education On November , President Lyndon Johnson signed The Higher Education Act of 1965 into law . With a stroke of the pen , he implemented what we know as the aid , work study , and student loan programs to help Americans pay for a college education . In his remarks , the President said Here the seeds were planted from which grew my conviction that individual , education is the path to achievement and Nation , it is a path to a society that is not only tree but civilized and for the world , it is the path to it is education that places reason over force . This Act , he said , is responsible for funding higher education for millions of Americans . It is the embodiment of the United States investment in human capital . Since Johnson signed the Act into law , the government has renewed it several times .

750 31 The Impacts of Government Borrowing The purpose of The Higher Education Act of 1965 was to build the country human capital by creating educational opportunity for millions of Americans . The three criteria that the government uses to judge eligibility are income , or attendance , and the cost of the institution . According to , in the school year , over 80 of all college students received some form of federal financial aid 43 received grants and another 41 of students aged received federal government student loans . The budget to support aid has increased not only because of more enrollment , but also because of increased tuition and fees for higher education . In 2022 , the government generally took an approach of increasing student aid through programs such as Pell Grant expansion , while also taking steps to ease student loan debt . Governments have many competing demands for support . Any spending should be tempered by responsibility and by looking carefully at the spending impact . When a government spends more than it collects in taxes , it runs a budget . It then needs to borrow . When government borrowing becomes especially large and sustained , it can substantially reduce the capital available to private sector , as well as lead to trade imbalances and even crises . The Government Budgets and Fiscal Policy chapter introduced the concepts of and debt , as well as how a government could use policy to address recession or . This chapter begins by building on the national savings and investment identity , which we introduced in The International Trade and Capital chapter , to show how government borrowing affects physical capital investment levels and trade balances . A prolonged period of budget may lead to lower economic growth , in part because the funds that the government borrows to fund its budget are typically no longer available for private investment . Moreover , a sustained pattern of large budget can lead to disruptive economic patterns of high , substantial of capital from abroad , plummeting exchange rates , and heavy strains on a country banking and system . How Government Borrowing Affects Investment and the Trade Balance LEARNING OBJECTIVES By the end of this section , you will be able to Explain the national saving and investment identity in terms of demand and supply Evaluate the role of budget surpluses and trade surpluses in national saving and investment identity When governments are borrowers in markets , there are three possible sources for the funds from a point of view ( households might save more ( private might borrow less and ( the additional funds for government borrowing might come from outside the country , from foreign investors . Let begin with a review one of these three options must occur , and then explore how interest rates and exchange rates adjust to these connections . The National Saving and Investment Identity The national saving and investment identity , which we introduced in The International Trade and Capital chapter , provides a framework for showing the relationships between the sources of demand and supply in capital markets . The identity begins with a statement that must always hold true the quantity of capital supplied in the market must equal the quantity of capital demanded . The economy has two main sources for capital private savings from inside the US . economy and public savings . Total savings Private savings ( Public savings ( These include the of foreign capital from abroad . The of savings from abroad is , by , equal to the trade , as we explained in The International Trade and Capital Flows chapter . We can write this of foreign investment capital as imports ( minus exports ( There are also two main sources of demand for capital private sector investment ( I ) and government borrowing . Government Access for free at

How Government Borrowing Affects Investment and the Trade Balance 751 borrowing in any given year is equal to the budget , which we can write as the difference between government spending ( and net taxes ( Let call this equation . Quantity supplied of financial capital Quantity demanded of capital Private savings of foreign savings Private investment Government budget deficit ( Governments often spend more than they receive in taxes and , therefore , public savings ( is negative . This causes a need to borrow money in the amount of ( instead of adding to the nation savings . If this is the case , we can view governments as of capital instead of suppliers . In algebraic terms , we can rewrite the national savings and investment identity like this Private investment savings Public savings deficit ( Let call this equation . We must accompany a change in any part of the national saving and investment identity by offsetting changes in at least one other part of the equation because we assume that the equality of quantity supplied and quantity demanded always holds . If the government budget changes , then either private saving or investment or the trade some combination of the change as well . Figure 312 shows the possible effects . Domestic private investment falls Domestic private investment rises Private savings rises Trade rises ( or trade surplus falls ) A Private savings falls Trade deficit falls ( or trade surplus rises ) Budget Deficit rises ( or budget surplus falls Budget falls ( or budget surplus rises la ) FIGURE Effects of Change in Budget Surplus or Deficit on Investment , Savings , and The Trade Balance Chart ( a ) shows the potential results when the budget rises ( or budget surplus falls ) Chart ( shows the potential results when the budget falls ( or budget surplus rises ) What about Budget Surpluses and Trade Surpluses ?

The national saving and investment identity must always hold true because , by , the quantity supplied and quantity demanded in the capital market must always be equal . However , the formula will look somewhat different if the government budget is in rather than surplus or if the balance of trade is in surplus rather than . For example , in 1999 and 2000 , the US . government had budget surpluses , although the economy was still experiencing trade . When the government was running budget surpluses , it was acting as a saver rather than a borrower , and supplying rather than demanding capital . As a result , we would write the national saving and investment identity during this time as Quantity supplied of financial demanded of financial capital Private savings Trade deficit Government investment ( Let call this equation . Notice that this expression is mathematically the same as equation except the savings and investment sides of the identity have simply sides . During the , the government was often running a budget , but the economy was typically running trade surpluses . Since a trade surplus means that an economy is experiencing a net of

752 31 The Impacts of Government Borrowing capital , we would write the national saving and investment identity as Quantity supplied of financial demanded of financial capital Private investment of foreign savings Government budget deficit ( Instead of the balance of trade representing part of the supply of capital , which occurs with a trade , a trade surplus represents an of capital leaving the domestic economy and invested elsewhere in the world . Quantity supplied of financial capital demanded of financial capital demand Private investment Government budget deficit Trade surplus ( We assume that the point to these equations is that the national saving and investment identity always hold . When you write these relationships , it is important to engage your brain and think about what is on the supply and demand side of the capital market before you start your calculations . As you can see in Figure , the of Management and Budget shows that the United States has consistently run budget since 1977 , with the exception of 1999 and 2000 . What is alarming is the dramatic increase in budget that has occurred since 2008 , which in part declining tax revenues and increased safety net expenditures due to the Great Recession . While were controlled as the economy began to recover in the , the budget increased again in 2020 during the pandemic , and forecasters expect to remain high for the foreseeable future . Recall that is net taxes . When the government must transfer funds back to individuals for safety net expenditures like Social Security and unemployment , budget rise . These have implications for the future health of the economy . 500 I ' I ' I I A A Federal surplus or deficit ( billions of dollars ) I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I ( be Ev go ( ho ) go 62 ' 55 55 ( Year FIGURE United States , Surplus , and Deficit , billions ) The United States has run a budget for over 30 years , with the exception of 1999 and 2000 . Military expenditures , entitlement programs , and the decrease in tax revenue coupled with increased safety net support during the Great Recession are major Access for free at

Fiscal Policy and the Trade Balance 753 contributors to the dramatic increases in the after 2008 . Source of Management and Budget , A rising budget may result in a fall in domestic investment , a rise in private savings , or a rise in the trade . The following modules discuss each of these possible effects in more detail . Fiscal Policy and the Trade Balance LEARNING OBJECTIVES By the end of this section , you will be able to Discuss twin as they related to budget and trade Explain the relationship between budget and exchange rates Explain the relationship between budget and Identify causes of Government budget balances can affect the trade balance . As The Perspective chapter discusses , a net of foreign investment always accompanies a trade , while a net of investment always accompanies a trade surplus . One way to understand the connection from budget to trade is that when government creates a budget with some combination of tax cuts or spending increases , it will increase aggregate demand in the economy , and some of that increase in aggregate demand will result in a higher level of imports . A higher level of imports , with exports remaining , will cause a larger trade . That means foreigners holdings increase as Americans purchase more imported goods . Foreigners use those dollars to invest in the United States , which leads to an of foreign investment . One possible source of funding our budget is foreigners buying Treasury securities that the government sells , thus a trade often accompanies a budget . Twin Deficits ?

In the , it was common to hear economists and even newspaper articles refer to the twin , as the budget and trade both grew substantially . Figure 3111 shows the pattern . The federal budget went from of in 1981 to of in drop of of . Over that time , the trade moved from in 1981 to in drop of of . In the an of foreign investment capital matched , the considerable increase in government borrowing , so the government budget and the trade moved together . Budget deficit 2004 Percentage of i ) Year FIGURE Budget Deficits and Trade Deficits In the 19805 , the budget and the trade declined at the same time . However , since then , the have stopped being twins . The trade grew smaller in the early as the budget increased , and then the trade grew larger in the late as the budget

754 31 The Impacts of Government Borrowing turned into a surplus . In the first half of the , both budget and trade increased . However , in 2009 , the trade declined as the budget increased . Through the , the trade remained relatively stable as the budget declined . While the budget increased in 2020 , there has been hardly any change in the trade deficit . Of course , no one should expect the budget and trade to move in lockstep , because the other parts of the national saving and investment and private often change as well . In the late , for example , the government budget balance turned from to surplus , but the trade remained large and growing . During this time , the of foreign investment was supporting a surge of physical capital investment by . In the half of the , the budget and trade again increased together , but in 2009 , the budget increased while the trade declined . Through the , as there were bigger changes in the budget , the trade remained stable . The budget and the trade are related to each other , but they are more like cousins than twins . Budget Deficits and Exchange Rates Exchange rates can also help to explain why budget are linked to trade . Figure 315 shows a situation using the exchange rate for the dollar , measured in euros . At the original equilibrium ( where the demand for dollars ( intersects with the supply of dollars ( So ) on the foreign exchange market , the exchange rate is euros per dollar and the equilibrium quantity traded in the market is 100 billion per day . Then the budget rises and foreign investment provides the source of funds for that budget . International investors , as a group , will demand more dollars on foreign exchange markets to purchase the government bonds , and they will supply fewer of the dollars that they already hold in these markets . Demand for dollars on the foreign exchange market shifts from Do to and the supply of dollars falls from to . At the new equilibrium ( the exchange rate has appreciated to euros per dollar while , in this example , the quantity of dollars traded remains the same . Exchange Rate ( Quantity of Dollars Traded ( billions per day ) FIGURE Budget Deficits and Exchange Rates Imagine that the government increases its borrowing and the funds come from European investors . To purchase government bonds , those European investors will need to demand more dollars on foreign exchange markets , causing the demand for dollars to shift to the right from Do to . European investors as a group will also be less likely to supply dollars to the foreign exchange markets , causing the supply of dollars to shift from to . The equilibrium exchange rate strengthens from dollar at to at . A stronger exchange rate , of course , makes it more for exporters to sell their goods abroad while making imports cheaper , so a trade ( or a reduced trade surplus ) results . Thus , a budget can easily result in an of foreign capital , a stronger exchange rate , and a trade . Access for free at

Fiscal Policy and the Trade Balance 755 You can also imagine interest rates are driving the exchange rate appreciation . As we explained earlier in Figure , a budget increases demand in markets for domestic capital , raising the domestic interest rate . A higher interest rate will attract an of foreign capital , and appreciate the exchange rate in response to the increase in demand for dollars by foreign investors and a decrease in supply of dollars . Because of higher interest rates in the United States , Americans bonds more attractive than foreign bonds . When Americans are buying fewer foreign bonds , they are supplying fewer dollars . dollar appreciation leads to a larger trade ( or reduced surplus ) The connections between of foreign investment capital , interest rates , and exchange rates are all just different ways of drawing the same economic connections a larger budget can result in a larger trade , although do not expect the connection to be . From Budget Deficits to International Economic Crisis We lay out the economic story of how an of international capital can cause a deep recession in the Exchange Rates and International Capital Flows chapter . When international investors decide to withdraw their funds from a country like Turkey , they increase the supply of the Turkish lira and reduce the demand for lira , depreciating the lira exchange rate . When and the government in a country like Turkey borrow money in international markets , they typically do so in stages . First , banks in Turkey borrow in a widely used currency like dollars or euros , then convert those dollars to lira , and then lend the money to borrowers in Turkey . Ifthe lira exchange rate value , then Turkey banks will it impossible to repay the international loans that are in dollars or euros . The combination of less foreign investment capital and banks that are bankrupt can sharply reduce aggregate demand , which causes a deep recession . Many countries around the world have experienced this kind of recession along with Turkey in 2002 , Mexico followed this general pattern in 1995 , Thailand and countries across East Asia in , Russia in 1998 , and Argentina in 2002 . In many of these countries , large government budget played a role in setting the stage for the crisis . A moderate increase in a budget that leads to a moderate increase in a trade and a moderate appreciation of the exchange rate is not necessarily a cause for concern . However , beyond some point that is hard to in advance , a series of large budget can become a cause for concern among international investors . One reason for concern is that extremely large budget mean that aggregate demand may shift so far to the right as to cause high . The example of Turkey is a situation where very large budget brought rates well into double digits . In addition , very large budget at some point begin to raise a fear that the government would not repay the borrowing . In the last 100 years , the government of Turkey has been unable to pay its debts and defaulted on its loans four times . Over the past 175 years , government has been unable to pay its debts and defaulted on its loans seven times Venezuela , nine times and Argentina , times . The risk of high or a default on repaying international loans will worry international investors , since both factors imply that the rate of return on their investments in that country may end up lower than expected . If international investors start withdrawing the funds from a country rapidly , the scenario of less investment , a exchange rate , widespread bank failure , and deep recession can occur . The following Clear It Up feature explains other impacts of large . CLEAR IT UP What are the risks of chronic large deficits in the United States ?

If a government runs large budget for a sustained period of time , what can go wrong ?

According to a recent Institution report , a key risk of a large budget is that government debt may grow too high compared to the country growth . As debt grows , the national savings rate will decline , leaving less available in capital for private investment . The impact of chronically large budget is as follows As the population ages , there will be an increasing demand for government services that may cause higher

756 31 The Impacts of Government Borrowing government . Government borrowing and its interest payments will pull resources away from domestic investment in human capital and physical capital that is essential to economic growth . Interest rates may start to rise so that the cost of financing government debt will rise as well , creating pressure on the government to reduce its budget through spending cuts and tax increases . These steps will be politically painful , and they will also have a effect on aggregate demand in the economy . Rising percentage of debt to will create uncertainty in the and global markets that might cause a country to resort to inflationary tactics to reduce the real value of the debt outstanding . This will decrease real wealth and damage in the country ability to manage its spending . After all , if the government has borrowed at a interest rate of , say , and it lets inflation rise above that , then it will effectively be able to repay its debt at a negative real interest rate . The conventional reasoning suggests that the relationship between sustained that lead to high levels of government debt and growth is negative . How this relationship is , how big an issue it is compared to other issues , and the direction of causality , is less clear . What remains important to acknowledge is that the relationship between debt and growth is negative and that for some countries , the relationship may be stronger than in others . It is also important to acknowledge the direction of causality does high debt cause slow growth , slow growth cause high debt , or are both high debt and slow growth the result of third factors ?

In our analysis , we have argued simply that high debt causes slow growth . There may be more to this debate than we have space to discuss here . Using Fiscal Policy to Address Trade If a nation is experiencing the of foreign investment capital associated with a trade because foreign investors are making direct investments in , there may be no substantial reason for concern . After all , many nations around the world would welcome direct investment by multinational that ties them more closely into the global networks and distribution of goods and services . In this case , the of foreign investment capital and the trade are attracted by the opportunities for a good rate of return on private sector investment in an economy . However , governments should beware of a sustained pattern of high budget and high trade . The danger arises in particular when the of foreign investment capital is not funding physical capital investment by , but instead is portfolio investment in government bonds . When of foreign investment reach high levels , foreign investors will be on the alert for any reason to fear that the country exchange rate may decline or the government may be unable to repay what it has borrowed on time . Just as a few falling rocks can trigger an avalanche a relatively small piece of bad news about an economy can trigger an enormous of capital . Reducing a nation budget will not always be a successful method of reducing its trade , because other elements of the national saving and investment identity , like private saving or investment , may change instead . In those cases when the budget is the main cause of the trade , governments should take steps to reduce their budget , lest they make their economy vulnerable to a rapid of international capital that could bring a deep recession . How Government Borrowing Affects Private Saving LEARNING OBJECTIVES By the end of this section , you will be able to Apply equivalence to evaluate how government borrowing affects private saving Interpret a graphic representation of equivalence A change in government budgets may impact private saving . Imagine that people watch government budgets and adjust their savings accordingly . For example , whenever the government runs a budget , people Access for free at

How Government Borrowing Affects Private Saving 757 might reason Well , a higher budget means that going to owe more taxes in the future to pay off all that government borrowing , so I start saving now . If the government runs budget surpluses , people might reason With these budget surpluses ( or lower budget ) interest rates are falling , so that saving is less attractive . Moreover , with a budget surplus the country will be able to afford a tax cut sometime in the future . I wo bother saving as much The theory that rational private households might shift their saving to offset government saving or borrowing is known as equivalence because the idea has intellectual roots in the writings of the early economist David Ricardo ( If equivalence holds completely true , then in the national saving and investment identity , any change in budget or budget surpluses would be completely offset by a corresponding change in private saving . As a result , changes in government borrowing would have no effect at all on either physical capital investment or trade balances . In practice , the private sector only sometimes and partially adjusts its savings behavior to offset government budget and surpluses . Figure shows the patterns of government budget and surpluses and the rate of private includes saving by both households and 1980 . The connection between the two is not at all obvious . In the , for example , government budget were quite large , but there is no corresponding surge of private saving . However , when budget turn to surpluses in the late , there is a simultaneous decline in private saving . When budget got very large in 2008 and 2009 , there was another a rise in saving . When the increased again in 2020 , saving jumped up as well . A variety of statistical studies based on the experience suggests that when government borrowing increases by , private saving rises by about 30 cents . A World Bank study from the late , looking at government budgets and private saving behavior in countries around the world , found a similar result . 35 30 25 20 10 I I I I I I , I I I ea or ' st , I ma IN , I Budget Year FIGURE Budget Deficits and Private Savings The theory of equivalence suggests that additional private saving will offset any increase in government borrowing , while reduced private saving will offset any decrease in government borrowing . Sometimes this theory holds true , and sometimes it does not . Source Bureau of Economic Analysis and Federal Reserve Economic Data ) Private saving does increase to some extent when governments run large budget , and private saving falls when governments reduce or run large budget surpluses . However , the offsetting effects of private saving compared to government borrowing are much less than . In addition , this effect can vary a great deal from country to country , from time to time , and over the short and the long run . If the funding for a larger budget comes from international investors , then a trade may accompany a budget . In some countries , this pattern of twin has set the stage for international investors to send their funds to a country and cause an appreciation of its exchange rate and

758 31 The Impacts of Government Borrowing then to pull their funds out and cause a depreciation of the exchange rate and a crisis as well . It depends on whether funding comes from international investors . Fiscal Policy , Investment , and Economic Growth LEARNING OBJECTIVES By the end of this section , you will be able to Explain crowding out and its effect on physical capital investment Explain the relationship between budget and interest rates Identify why economic growth is tied to investments in physical capital , human capital , and technology The underpinnings growth are investments in physical capital , human capital , and technology , all set in an economic environment where and individuals can react to the incentives provided by functioning markets and prices . Government borrowing can reduce the capital available for private to invest in physical capital . However , government spending can also encourage certain elements of growth , such as spending on roads or water systems , on education , or on research and development that creates new technology . Crowding Out Physical Capital Investment A larger budget will increase demand for capital . saving and the trade balance remain the same , then less capital will be available for private investment in physical capital . When government borrowing soaks up available capital and leaves less for private investment in physical capital , economists call the result crowding out . To understand the potential impact of crowding out , consider the US . economy situation before the exceptional circumstances of the recession that started in late 2007 . In 2005 , for example , the budget was roughly . Private investment by in the US . economy has hovered in the range of 14 to 18 of in recent decades . However , in any given year , roughly half of US . investment in physical capital just replaces machinery and equipment that has worn out or become technologically obsolete . Only about half represents an increase in the total quantity of physical capital in the economy . Investment in new physical capital in any year is about to of . In this situation , even budget in the range of of can potentially crowd out a substantial share of new investment spending . Conversely , a smaller budget ( or an increased budget surplus ) increases the pool of capital available for private investment . LINK IT UP Visit this website to view the US . Debt Figure 317 shows the patterns of budget and private investment since 1980 . government lead to less private investment in physical capital , and reduced government or budget surpluses lead to more investment in physical capital , these two lines should move up and down simultaneously . This pattern occurred in the late and early . The federal budget went from a of in 1995 to a budget surplus of of in swing of . From 1995 to 2000 , private investment in physical capital rose from 15 to 18 of rise of of . Then , when the US . government again started running budget in the early , less capital became available for private investment , and the rate investment fell back to about 15 of by 2003 . However , in more recent years , in the after the economy recovered from the Great Recession , private investment as a share of increased even as slightly worsened , especially around 2016 . And while the increased substantially in 2020 , private investment as a share of did not . Access for free at

Fiscal Policy , Investment , and Economic Growth 759 25 20 Government ' 10 borrowing turns to saving . freeing up financial capital for private investment I co no Budget Year FIGURE Budget and Private connection between private savings and flows of international capital plays a role in budget and surpluses . Consequently , government borrowing and private investment sometimes rise and fall together . For example , the 19905 show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment . This argument does not claim that a government budget will exactly shadow its national rate of private investment after all , we must account for private saving and of foreign investment . In the , for example , government budget increased substantially without a corresponding drop off in private investment . In 2009 , nonresidential private investment dropped by 300 billion from its previous level of billion in 2008 , primarily because , during a recession , lack both the funds and the incentive to invest . Investment growth between 2009 and 2014 averaged approximately to slightly above its 2008 level , according to the Bureau of Economic Analysis . During that same period , interest rates dropped from to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering interest rates . The crowding out of private investment due to government borrowing to expenditures appears to have been suspended after the Great Recession . The Interest Rate Connection Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment . How will this affect interest rates in markets ?

In Figure , the original equilibrium ( where the demand curve ( Do ) for capital intersects with the supply curve ( occurs at an interest rate of and an equilibrium quantity equal to 20 of . However , as the government budget increases , the demand curve for capital shifts from Do to . The new equilibrium ( occurs at an interest rate of and an equilibrium quantity of 21 of . Interest Rate ( 20 21 Quantity of Financial Capital ( of ) FIGURE Budget Deficits and Interest Rates In the market , an increase in government borrowing can

760 31 The Impacts of Government Borrowing shift the demand curve for capital to the right from Do to . As the equilibrium interest rate shifts from to , the interest rate rises from to in this example . The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment . A survey of economic studies on the connection between government borrowing and interest rates in the economy suggests that an increase of in the budget will lead to a rise in interest rates and , other factors held equal . In turn , a higher interest rate tends to discourage from making physical capital investments . One reason government budget crowd out private investment , therefore , is the increase in interest rates . There are , however , economic studies that show a limited connection between the two ( at least in the United States ) but as the budget grows , the dangers of rising interest rates become more real . At this point , you may wonder about the Federal Reserve . After all , can the Federal Reserve not use expansionary monetary policy to reduce interest rates , or in this case , to prevent interest rates from rising ?

This useful question emphasizes the importance of considering how and monetary policies work in relation to each other . Imagine a central bank faced with a government that is running large budget , causing a rise in interest rates and crowding out private investment . If the budget are increasing aggregate demand when the economy is already producing near potential , threatening an increase in price levels , the central bank may react with a monetary policy . In this situation , the higher interest rates from the government borrowing would be made even higher by monetary policy , and the government borrowing might crowd out a great deal of private investment . Alternatively , if the budget are increasing aggregate demand when the economy is producing substantially less than potential , an increase in the price level is not much ofa danger and the central bank might react with expansionary monetary policy . In this situation , higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy , and there would be little crowding out investment . However , even a central bank can not erase the overall message of the national savings and investment identity . If government borrowing rises , then private investment must fall , or private saving must rise , or the trade must rise . By reacting with or expansionary monetary policy , the central bank can only help to determine which of these outcomes is likely . Public Investment in Physical Capital Government can invest in physical capital directly roads and bridges water supply and sewers and airports schools and hospitals plants that generate electricity , like hydroelectric dams or windmills telecommunications facilities and military weapons . In 2021 , the United States spent about 146 billion on transportation , including highways , mass transit , and airports . Table shows the federal governments total outlay for 2021 for major public physical capital investment in the United States . We have omitted physical capital related to the military or to residences where people live from this table , because the focus here is on public investments that have a direct effect on raising output in the private sector . Type of Public Physical Capital Federal 2014 Federal 2021 Transportation Community and regional development Natural resources and the environment TABLE Grants for Major Physical Capital Investment , 2014 and 2021 , in Millions ( Source Bureau of Economic Analysis , Table , Access for free at

Fiscal Policy , Investment , and Economic Growth 761 Type of Public Physical Capital Federal 2014 Federal 2021 Education , training , employment , and social services Other Total TABLE Grants for Major Physical Capital Investment , 2014 and 2021 , in Millions ( Source Bureau of Economic Analysis , Table , Public physical capital investment of this sort can increase the economy output and productivity . An economy with reliable roads and electricity will be able to produce more . However , it is hard to quantify how much government investment in physical capital will the economy , because government responds to political as well as economic incentives . When a makes an investment in physical capital , it is subject to the discipline of the market If it does not receive a positive return on investment , the firm may lose money or even go out of business . In some cases , lawmakers make investments in physical capital as a way of spending money in key politicians districts . The result may be unnecessary roads or office buildings . Even ifa project is useful and necessary , it might be done in a way that is excessively costly , because local contractors who make campaign contributions to politicians appreciate the extra business . Alternatively , governments sometimes do not make the investments they should because a decision to spend on infrastructure does not need to just make economic sense . It must be politically popular as well . Managing public investment can be . If a government decides to an investment in public physical capital with higher taxes or lower government spending in other areas , it need not worry that it is directly crowding out private investment . Indirectly however , higher household taxes could cut down on the level savings available and have a similar effect . If a government decides to an investment in public physical capital by borrowing , it may end up increasing the quantity physical capital at the cost of crowding out investment in private physical capital , which could be more to the economy . Public Investment in Human Capital In most countries , the government plays a large role in society investment in human capital through the education system . A highly educated and skilled workforce contributes to a higher rate of economic growth . For the nations of the world , additional investment in human capital seems likely to increase productivity and growth . For the United States , critics have raised tough questions about how much increases in government spending on education will improve the actual level of education . Among economists , discussions of education reform often begin with some uncomfortable facts . As Fig shows , spending per student for kindergarten through grade 12 ( increased substantially in real dollars through 2010 , declined slightly in 2011 and 2012 , and began rising again after that through 2020 . However , as measured by standardized tests like the SAT , the level of student academic achievement has barely budged in recent decades . On international tests , students lag behind students from many other countries . Of course , test scores are an imperfect measure of education for a variety of reasons . It would be , however , to argue that there are not real problems in the education system and that the tests are just inaccurate .

762 31 The Impacts of Government Borrowing Sam 703 SHIN 3409 Sim if , 311 ' Year FIGURE Total Elementary , Secondary , and Vocational Education ( in the United States The graph shows that government spending on education was continually increasing up until 2006 where it leveled off until 2008 when it increased dramatically . Since 2010 , spending has steadily decreased . Source of Management and Budget ) The fact that increased resources have not brought greater measurable gains in student performance has led some education experts to question whether the problems may be due to structure , not just to the resources spent . Other government programs seek to increase human capital either before or after the education system . Programs for early childhood education , like the federal Head Start program , are directed at families where the parents may have limited educational and resources . Government also offers substantial support for universities and colleges . For example , in the United States about 60 of students take at least a few college or university classes beyond the high school level . In Germany and Japan , about half of all students take classes beyond the comparable high school level . In the countries of Latin America , only about one student in four takes classes beyond the high school level , and in the nations of Africa , only about one student in 20 . Not all spending on educational human capital needs to happen through the government many college students in the United States pay a substantial share of the cost of their education . countries of the world are going to experience a widespread increase in their education levels for children , government spending seems likely to play a substantial role . For the economy , and for other countries , the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate , rather than dramatic increases in education spending . How Fiscal Policy Can Improve Technology Research and development ( efforts are the lifeblood of new technology . According to the National Science Foundation , federal for research , development , and physical plant improvements to various governmental agencies have remained at an average of . About of spending goes to defense and research . Although spending may sometimes produce , that is aimed at producing new weapons is less likely to the civilian economy than direct civilian spending . Fiscal policy can encourage using either direct spending or tax policy . Government could spend more on the that it carries out in government laboratories , as well as expanding federal grants to universities and colleges , organizations , and the private sector . By 2014 , the federal share of totaled billion , or about of the federal government total budget , according to data from the Access for free at

Fiscal Policy , Investment , and Economic Growth 763 National Science Foundation . Fiscal policy can also support through tax incentives , which allow to reduce their tax bill as they increase spending on research and development . Summary of Fiscal Policy , Investment , and Economic Growth Investment in physical capital , human capital , and new technology is essential for economic growth , as Table summarizes . In a economy , private will undertake most of the investment in physical capital , and policy should seek to avoid a long series of outsized budget that might crowd out such investment . We will see the effects of many policies very gradually over time , as students are better educated , we make physical capital investments , and man invents and implements new technologies . Physical Capital Human Capital New Technology Private New investment in , Research and development Sector property and equipment training Public , Public education Research and development encouraged through private Public infrastructure , Sector Job training sector incentives and direct spending . TABLE Investment Role of Public and Private Sector in a Market Economy BRING IT HOME Financing Higher Education According to the Bureau of Labor Statistics , between 1980 and 2020 , the average tuition and fees at a public university increased from 738 to . This represents a more than increase in this 40 year period . To put this increase into perspective , median yearly household income in the has increased from about to during the same a increase . Clearly , college is becoming increasingly expensive , even as it continues to provide the same that were mentioned at the beginning of this chapter by President Lyndon Johnson . Crucial to the mission of higher education is the Pell Grant program , which was initiated by President Johnson as part of the Higher Education Act of 1965 . But Pell Grant amounts have not adequately kept up with the rising costs of college tuition and fees . As part of President Joe Build Back Better proposal , the maximum Pell Grant award would increase to between , representing an increase , which is one of the largest increases in the last 20 years ( the largest increase occurred between 2009 and 2010 , during President Barack Obama term in office ) The original proposal also aimed to allow for Deferred Action for Childhood Arrivals program participants to from the awards , through 2030 .

764 31 Key Terms Key Terms Head Start program a program for early childhood education directed at families with limited educational and resources . equivalence the theory that rational private households might shift their saving to offset government saving or borrowing twin that occur when a country is running both a trade and a budget Key Concepts and Summary How Government Borrowing Affects Investment and the Trade Balance A change in any part of the national saving and investment identity suggests that if the government budget changes , then either private savings , private investment in physical capital , or the trade some combination of the change as well . Fiscal Policy and the Trade Balance The government need not balance its budget every year . However , a sustained pattern of large budget over time risks causing several negative outcomes a shift to the right in aggregate demand that causes an increase in the price level crowding out private investment in physical capital in a way that slows down economic growth and creating a dependence on of international portfolio investment which can sometimes turn into of foreign investment that can be injurious to a . How Government Borrowing Affects Private Saving The theory of equivalence holds that changes in private saving will offset changes in government borrowing or saving . Thus , greater private saving will offset higher budget , while greater private borrowing will offset larger budget surpluses . If the theory holds true , then changes in government borrowing or saving would have no effect on private investment in physical capital or on the trade balance . However , empirical evidence suggests that the theory holds true only partially . Fiscal Policy , Investment , and Economic Growth Economic growth comes from a combination of investment in physical capital , human capital , and technology . Government borrowing can crowd out private sector investment in physical capital , but policy can also increase investment in publicly owned physical capital , human capital ( education ) and research and development . Possible methods for improving education and society investment in human capital include spending more money on teachers and other educational resources , and reorganizing the education system to provide greater incentives for success . Methods for increasing research and development spending to generate new technology include direct government spending on and tax incentives for businesses to conduct additional . Questions . In a country , private savings equals 600 , the government budget surplus equals 200 , and the trade surplus equals 100 . What is the level of private investment in this economy ?

Assume an economy has a budget surplus of , private savings of , and investment of a . Write out a national saving and investment identity for this economy . What will be the balance of trade in this economy ?

If the budget surplus changes to a budget of 1000 , with private saving and investment unchanged , what is the new balance of trade in this economy ?

Access for free at 31 Review Questions 765 . In the late , the government moved from a budget to a budget surplus and the trade in the economy grew substantially . Using the national saving and investment identity , what can you say about the direction in which saving investment must have changed in this economy ?

Imagine an economy in which equivalence holds . This economy has a budget of 50 , a trade of 20 , private savings of 130 , and investment of 100 . If the budget rises to 70 , how are the other terms in the national saving and investment identity affected ?

Why have many education experts recently placed an emphasis on altering the incentives that schools face rather than on increasing their budgets ?

Without endorsing any of these proposals as especially good or bad , list some of the ways in which incentives for schools might be altered . What are some steps the government can take to encourage research and development ?

Review Questions . Based on the national saving and investment identity , what are the three ways the might react to greater government budget ?

How would you expect larger budget to affect private sector investment in physical capital ?

Why ?

Under what conditions will a larger budget cause a trade ?

10 . Wiat is the theory of equivalence ?

11 . Wiat does the concept of rationality have to do with equivalence ?

12 . Wiat are some of the ways policy might encourage economic growth ?

13 . Wiat are some policies for improving a society human capital ?

14 . Wiat are some policies for improving the technologies that the economy will have to draw upon in the future ?

15 . Explain how cuts in funding for programs such as Head Start might affect the development of human ca in the United States . Critical Thinking Questions 16 . Assume there is no discretionary increase in government spending . Explain how an improving economy wi affect the budget balance and , in turn , investment and the trade balance . 17 . Ex alain how decreased domestic investments that occur due to a budget will affect future economic growth . 18 . The government has shut down a number of times in recent history . Explain how a government shutdown will affect the variables in the national investment and savings identity . Could the shutdown affect the government budget ?

19 . Explain how a shift from a government budget to a budget surplus might affect the exchange rate . 20 . Describe how a plan for reducing the government might affect a college student , a young professional , and a family . 21 . Explain whether or not you agree with the premise of the equivalence theory that rational people might reason Well , a higher budget ( surplus ) means that going to owe more ( less ) taxes in the future to pay off all that government borrowing , so I start saving ( spending ) Why or why not ?

22 . Explain why the government might prefer to provide incentives to private to do investment or research and development , rather than simply doing the spending itself ?

766 31 Problems 23 . 24 . Under what condition would crowding out not inhibit economic growth ?

Under what condition would crowding out impede economic growth ?

What must take place for the government to run without any crowding out ?

Problems 25 . 26 . 27 . 28 . 29 . Sketch a diagram of how a budget causes a trade . Hint Begin with what will happen to the exchange rate when foreigners demand more government debt . Sketch a diagram of how sustained budget cause low economic growth . Assume that the newly independent government of employed you in 1964 . Now free from British rule , the Tanzanian parliament has decided that it will spend 10 million shillings on schools , roads , and healthcare for the year . You estimate that the net taxes for the year are eight million shillings . The government will the difference by selling government bonds at 12 interest per year . Parliament must add the interest on outstanding bonds to government expenditure each year . Assume that Parliament places additional taxes to this increase in government expenditure so the gap between government spending is always two million . If the school , road , and healthcare budget are unchanged , compute the value of the accumulated debt in 10 years . Illustrate the concept of equivalence using the demand and supply of capital graph . During the most recent recession , some economists argued that the change in the interest rates that comes about due to spending implied in the demand and supply of capital graph would not occur . A simple reason was that the government was stepping in to invest when private were not . Using a graph , explain how the use by government in investment offsets the demand . Access for free at