The Effect of a Government Budget Deficit When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. Here, when the supply shifts from S1 to $2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $120 billion to $80 billion. Interest S2 Rate Supply, S1 6% 1. A budget deficit decreases the 5%-..... supply of loanable funds . . . 2. .. . which raises the equilibrium Demand interest rate . . . $80-$120 Loanable Funds @2018 Cengage Learning (in billions of dollars) 3. . . . and reduces the equilibrium quantity of loanable funds. First, which curve shifts when the government starts running a budget deficit? Recall that national saving-the source of the supply of loanable funds-is composed of private saving and public saving. A change in the government budget balance represents a change in public saving and, thereby, in the supply of loanable funds. Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds.Second, which way does the supply curve shift? When the government runs a budget deficit, public saving is negative, and this reduces national saving. In other words, when the government borrows to finance its budget deficit, it reduces the supply of loanable funds available to finance investment by households and firms. Thus, a budget deficit shifts the supply curve for loanable funds to the left from S1 to S2, as shown in Figure 8.4. Third, we can compare the old and new equilibria. In the figure, when the budget deficit reduces the supply of loanable funds, the interest rate rises from 5 percent to 6 percent. This higher interest rate then alters the behaviour of the households and firms that participate in the loan market. In particular, many demanders of loanable funds are discouraged by the higher interest rate. Fewer families buy new homes, and fewer firms choose to build new factories. The fall in investment because of government borrowing is called crowding out and is represented in the figure by the movement along the demand curve from a quantity of $120 billion in loanable funds to a quantity of $80 billion. That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment. 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.FIGURE 8.3 An Increase in the Demand for Loanable Funds If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 to D2, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $140 billion. Interest Rate Supply 1. An investment tax credit increases 6% ..... the demand for loanable funds . . . 5% ......................................... 2. . . . which raises the D2 equrllbnum interest rate . . . 0 $12 $140 Loanable Funds (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 6 2018 C-engage Leaning FIGURE 8.2 An Increase in the Supply of Loanable Funds A change in the tax laws to encourage Canadians to save more would shift the supply of loanable funds to the right from 81 to 5'2. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the equilibrium quantity of loanable funds saved and invested rises from $120 billion to $160 billion. Interest Su I .5 5 Rate DPY 1 2 1. Tax incentives for sawing Increase the SUPP\" f \"mama 4% funds . . . 2. . . . which Demand reduces the equilibrium interest rate . . . 0 $120? $160 Loanable Funds 1" (in billions of dollars) 3. . . . and raises the equilibrium quantity of loanable funds. 0 2018 C-engage Learring