Critical Thinking Questions

you say about the direction in which saving and/or investment must have changed in this economy? 4 . Imagine an economy in which Ricardian equivalence holds. This economy has a budget deficit of 50, a trade deficit of 20, private savings of 130, and investment of 100. If the budget deficit rises to 70, how are the other terms in the national saving and investment identity affected? 5 . Why have many education experts recently placed an emphasis on altering the incentives that U.S. schools face rather than on increasing their budgets? Without endorsing any of these proposals as especially good or bad, list some of the ways in which incentives for schools might be altered. 6 . What are some steps the government can take to encourage research and development?

Review Questions

7 . Based on the national saving and investment identity, what are the three ways the macroeconomy might react to greater government budget deficits? 8 . How would you expect larger budget deficits to affect private sector investment in physical capital? Why? 9 . Under what conditions will a larger budget deficit cause a trade deficit? 10 . What is the theory of Ricardian equivalence? 11 . What does the concept of rationality have to do with Ricardian equivalence? 12 . What are some of the ways fiscal policy might encourage economic growth? 13 . What are some fiscal policies for improving a society’s human capital? 14 . What are some fiscal policies for improving the technologies that the economy will have to draw upon in the future? 15 . Explain how cuts in funding for programs such as Head Start might affect the development of human capital in the United States.

Critical Thinking Questions

16 . Assume there is no discretionary increase in government spending. Explain how an improving economy will affect the budget balance and, in turn, investment and the trade balance. 17 . Explain how decreased domestic investments that occur due to a budget deficit will affect future economic growth. 18 . The U.S. government has shut down a number of times in recent history. Explain how a government shutdown will affect the variables in the national investment and savings identity. Could the shutdown affect the government budget deficit? 19 . Explain how a shift from a government budget deficit to a budget surplus might affect the exchange rate. 20 . Describe how a plan for reducing the government deficit might affect a college student, a young professional, and a middle-income family. 21 . Explain whether or not you agree with the premise of the Ricardian equivalence theory that rational people might reason: “Well, a higher budget deficit (surplus) means that I’m just going to owe more (less) taxes in the future to pay off all that government borrowing, so I’ll start saving (spending) now.” Why or why not? 22 . Explain why the government might prefer to provide incentives to private firms to do investment or research and development, rather than simply doing the spending itself? 23 . Under what condition would crowding out not inhibit long-run economic growth? Under what condition would crowding out impede long-run economic growth? 24 . What must take place for the government to run deficits without any crowding out?

Problems

25 . Sketch a diagram of how a budget deficit causes a trade deficit. (Hint: Begin with what will happen to the exchange rate when foreigners demand more U.S. government debt.) 26 . Sketch a diagram of how sustained budget deficits cause low economic growth. 27 . Assume that the newly independent government of Tanzania employed you in 1964. Now free from British rule, the Tanzanian parliament has decided that it will spend 10 million shillings on schools, roads, and healthcare for the year. You estimate that the net taxes for the year are eight million shillings. The government will finance the difference by selling 10-year government bonds at 12% interest per year. Parliament must add the interest on outstanding bonds to government expenditure each year. Assume that Parliament places additional taxes to finance this increase in government expenditure so the gap between government spending is always two million. If the school, road, and healthcare budget are unchanged, compute the value of the accumulated debt in 10 years. 28 . Illustrate the concept of Ricardian equivalence using the demand and supply of financial capital graph. 29 . During the most recent recession, some economists argued that the change in the interest rates that comes about due to deficit spending implied in the demand and supply of financial capital graph would not occur. A simple reason was that the government was stepping in to invest when private firms were not. Using a graph, explain how the use by government in investment offsets the deficit demand.