Important Clarifications on Tutorial 9, Question 3

1) ” Why does public savings increase?”

Public Savings = T-G
When government borrow, they can spend more, so G increase, hence public savings decrease, which is equivalent to saying the government is running a budget deficit (G>T).

2. ” Private Savings = Y-T-C, which increase due to higher interest rate
Public Savings = T-G, which decrease
National Savings (S) = Private Savings + Public Savings
Since private savings increase and public savings decrease, national savings is indefinite, right?”

You cannot use “National Savings (S) = Private Savings + Public Savings” to determine what happen to natioanl savings. But we know that national savings will fall in this case. When interest rate increase, firms will borrow less and invest less, hence investment (I) decrease. Now at the aggregate level, National Savings (S) = Investment (I), so to achieve equilibrium, a falling investment will induce falling national savings and this continue until equilibrium is re-established.

3. “Why does the government borrowing not lead to an increase in demand for loanable funds?”

The government does not borrow on the loanable funds market directly. A common way is to issue bonds which are sold to the commercial banks. The banks will then use the saving deposits to pay for these bonds, thus reducing the amount of savings or loanable funds available. Hence government borrowing leads to a decrease in supply of loanable funds, NOT an increase in demand.

Ricardian Equivalence

We mentioned this in class. Read more about the Ricardian Equivalence.