ECO 226 Problems Chapter 12 Solution, Spring 2017

CHAPTER 12 Budget Balance and Government Debt ANSWERS TO TEXT PROBLEMS 1. At the current equilibrium interest rate of 8 percent, the allocation of credit is $500 billion for invest- ment, $100 billion to consumer credit, and $100 billion to government. An increase in government demand will crowd out some consumer and investment credit and also increase the quantity of loanable funds demanded. If there is anticipation of an increase in future taxes, the supply of credit will increase, putting downward pressure on interest rates. 2. Each time the debt is repaid, income will flow from U.S. citizens to foreigners. 3. Classical economists believed that prices were flexible enough to keep the economy at full employ- ment at almost all times. Under such circumstances, an increase in government spending, no matter how financed, could only reallocate resources from private to government use. 4. a. Other things being equal, national saving will increase, assuming that the supply of private saving does not decrease as the government relies less on borrowing and more on taxes. b. Interest rates will fall, assuming that the supply of private saving does not decrease as the gov- ernment relies less on borrowing and more on taxes. c. Private investment will increase, assuming that the supply of private saving does not decrease as the government relies less on borrowing and more on taxes and assuming that investment demand is responsive to a decline in interest rates. d. Economic growth in the future will increase because of higher saving and higher investment rates. e. An increase in economic growth will improve future living standards. 5. Personal saving is 1 percent of GNP. A surplus amounts to government saving, so a federal budget surplus will increase national saving. A budget deficit is negative government saving and will reduce national saving. Other things being equal, a federal budget deficit increases the demand for credit and bids up interest rates. This, combined with the fact that the deficit absorbs savings that would otherwise finance investment, can decrease investment in the United States and decrease future economic growth. 97