Self-Check Questions

Key Terms

Head Start program a program for early childhood education directed at families with limited educational and financial resources. Ricardian equivalence the theory that rational private households might shift their saving to offset government saving or borrowing twin deficits deficits that occur when a country is running both a trade and a budget deficit

Key Concepts and Summary

18.1 How Government Borrowing Affects Investment and the Trade Balance

A change in any part of the national saving and investment identity suggests that if the government budget deficit changes, then either private savings, private investment in physical capital, or the trade balance—or some combination of the three—must change as well.

18.2 Fiscal Policy and the Trade Balance

The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several negative macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level; crowding out private investment in physical capital in a way that slows down economic growth; and creating a dependence on inflows of international portfolio investment which can sometimes turn into outflows of foreign financial investment that can be injurious to a macroeconomy.

18.3 How Government Borrowing Affects Private Saving

The theory of Ricardian equivalence holds that changes in private saving will offset changes in government borrowing or saving. Thus, greater private saving will offset higher budget deficits, while greater private borrowing will offset larger budget surpluses. If the theory holds true, then changes in government borrowing or saving would have no effect on private investment in physical capital or on the trade balance. However, empirical evidence suggests that the theory holds true only partially.

18.4 Fiscal Policy, Investment, and Economic Growth

Economic growth comes from a combination of investment in physical capital, human capital, and technology. Government borrowing can crowd out private sector investment in physical capital, but fiscal policy can also increase investment in publicly owned physical capital, human capital (education), and research and development. Possible methods for improving education and society’s investment in human capital include spending more money on teachers and other educational resources, and reorganizing the education system to provide greater incentives for success. Methods for increasing research and development spending to generate new technology include direct government spending on R&D and tax incentives for businesses to conduct additional R&D.

Self-Check Questions

1 . In a country, private savings equals 600, the government budget surplus equals 200, and the trade surplus equals 100. What is the level of private investment in this economy? 2 . Assume an economy has a budget surplus of 1,000, private savings of 4,000, and investment of 5,000. a. Write out a national saving and investment identity for this economy. b. What will be the balance of trade in this economy? c. If the budget surplus changes to a budget deficit of 1000, with private saving and investment unchanged, what is the new balance of trade in this economy? 3 . In the late 1990s, the U.S. government moved from a budget deficit to a budget surplus and the trade deficit in the U.S. economy grew substantially. Using the national saving and investment identity, what can 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