Question 3 (15%)

Suppose the government borrows $20 billion more next year than this year.

1. a. Use a supply-and-demand diagram to analyse this policy. Does the interest rate rise or fall? (5%)
2. b. What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing. (5%)
3. c. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects that you discussed in parts (a) and (b)? (5%)