In this post I am going to work through an example relating to the market for loanable funds. The question is what happens when the government borrows $20 billion more next year than this year.
What happens to the interest rate
When the government runs a deficit, it means that they are spending more money then they are collecting in tax revenue. Therefore, they are required to borrow money from the money market.
When they borrow money from the money market, it reduces the supply available and therefore reduces the amount available for the private sector. Thus the supply curve shifts to the left and this raises the interest rate
As you can see from the diagram, the quantity of funds being borrowed reduces from Q1 to Q2 and the interest rate increases from IR1 to IR2.
This is called the "crowding out effect" because the government borrowing money stops private firms and households from being able to borrow money from the money market because the price (the interest rate) is increased and makes it no longer viable for them to borrow money.
What happens to investment? To private savings? To public savings? To national saving?
Investment is negatively correlated with the interest rate. The higher the interest rate, the lower investment and vice versa - which makes sense, as you would be less likely to borrow money to build a house when interest rates are high compared to when they are low, all other things being equal.
This means that the government running a budget deficit decrease the level of investment.
Private savings is defined as follows:
S = Y - T - C
where Y is National income, T is tax, and C is consumption. This equation says that savings equals how much you have left over after you pay your taxes and consume.
Since G (government spending) does not come into that equation, there is no impact on private savings.
Public savings is defined as follows:
Public savings = T - G
where T is tax and G is government spending. This again is pretty intuitive. What the government does not spend is how much it saves. When a government runs a budget deficit G is larger than T and therefore Public savings is negative.
National savings equals public savings plus private savings. Therefore, since public savings is unaffected and private savings is negative, the level of national savings decreases.
In summary the follow happens:
- Interest rates increase
- The supply of loanable funds decreases
- Private savings is unaffected
- Public savings is negative
- National savings decreases