1. Suppose we started out at the steady state capital stock in the basic Solow growth model. If the government increased the budget deficit (ceteris paribus) with no effect on the demand for loanable funds from private businesses, then we would expect to see what effects on:

a. (T - G) and hence the supply of loanable funds (hint: see the answer to #5 in Ch. 6)

b. the nation's capital stock as we move from the original steady state to the new one (and output per worker, y).

c. immediate-term consumption and equilibrium economic output (hint: see p. 152 of the coursepack)

(a. hint attached below)

(c. hint attached below)

5. b A higher budget deficit can, of course, be caused by an increase in Government Spending (G) with no change in Tax Revenues (T). Note that if G increases from 100 to 110 and T = 80 (and stays there), then (T G) decreases from ' 20' to ' 30' ('decreases' because it would become more negative). Intuitively, the government is 'dis saving' to a larger degree. In other words, net government savings has decreased. 1. Suppose we started out at the steady state capital stock in the basic Solow growth model. Ifthe government increased the budget decit (ceteris paribus) with no effect on the demand for loanable funds from private businesses, then we would expect to see what effects on a. (T G) and hence the supply of loanable funds (hint: see the answer to #5 in Ch. 6) b. the nation's capital stock as we move from the original steady state to the new one (and output per worker, y). c. immediateterm consumption and equilibrium economic output (hint: see p. 152 of the coursepack) Hi.) 5 FR.) ( = '1" in LF equibrium} Chapter 7 state capital stock, ceteris paribus, from &. to ; would cause the vertical Long-Run Aggregate Supply curve to shift to the right, from LR Agg So to LR Agg Si on Fig. 7 below. Figure 7: Increase in the Long-Run Aggregate Supply Curve P LR LR Agg S Agg S e (o) The increase in the capital stock makes workers more productive. Thus, we get more output in the new steady- state capital stock than we did in the prior, smaller steady-state capital stock. Recall that we do not get this shift immediately. It takes time as the capital stock grows (from . to Ri in our example for Fig. 6). This is an important way that we can conceptualize seeing positive growth rates over long periods of time in many countries. If the vertical Long-Run Aggregate Supply curve of Ch. 4 never shifted, then we might just fluctuate around the full-employment level of production (real GDP) and see average growth rates to be around 0 over many years. B. Increasing Savings with Policies to Increase the Supply of Loanable Funds Next, consider how to increase the supply of loanable funds (savings). If we now allow for the fact that the US has been running budget deficits for many years now, we could think of government borrowing as negative saving (and thereby reducing overall national savings). Thus, if the government increased income taxes (and thereby reduced the budget deficit (as long as they did not increase government spending by as much as they increased taxes!)), national savings would actually increase. This may seem odd, but you can think of the government borrowing (to finance deficit) spending as 'eating up' some of the loanable funds that would otherwise be available to businesses for investment. Thus, if the government reduced the deficit, they would not need to borrow as much. Therefore, there would tend to be more loanable funds available for private business investment. This would shift the supply of loanable funds curve (of Fig. 2) to the right (because the government's negative saving would not be as negative as it used to be!). Then the analysis of Fig. 6 would still apply. However, the savings rate is increasing for a different reason here, as described above. The equilibrium quantity of loanable funds would be higher (as desired) and the equilibrium interest rate would be lower (which is necessary to give businesses incentive to borrow the increase in availability of loanable funds). The short-run drawback here is that the increase in personal income taxes will reduce disposable income, which in turn will reduce Consumption. If we start from a steady-state long-run equilibrium, the reduction in Consumption, ceteris paribus, would cause a decrease in Aggregate Demand. Thus, we would slip into a recession in the short run (again assuming we started from a steady-state equilibrium). Note that the government could also do the same thing here by decreasing government spending (which would lower the deficit as well)