Suppose the government borrows $5 billion more next year than this year (for example, they move from a balanced budget to a $5 billion deficit or from a $10 billion deficit to a $15 billion deficit).

A)Use a supply-and-demand diagram to analyse this policy. Does the interest rate rise or fall?

B)What happens to investment? To private saving? To public saving? To national saving? Compare the size of the equilibrium changes with the $5 billion of extra borrowing. Is it the same, less, or more? Carefully explain why and distinguish the various movements in the diagram.

C)How do the elasticities of supply of and demand for loanable funds (i.e. the slopes of the curves) affect the size of these changes? (Hint: See chapter 5 to review the definition of elasticity.)

D)Suppose households believe that greater government saving today implies lower future taxes since there will be little government debt. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?