Deficit or Surplus
Effects of Federal Budget Deficit or Surplus
Q4. Explain why a federal budget surplus increases national savings, while a budget deficit decreases national savings.
Reply: A government’s budget balance is the difference in government revenue and spending. When the federal expenditure is less than federal revenue, the federal budget is in surplus. National savings is the sum of private and public savings. In the case of the budget surplus, the government sector is a net contributor to national savings. This causes an increase in national savings.
When federal budget is in deficit, the federal expenditure is more than federal revenue and the federal government has to borrow from the credit market to finance public expenditures. That means instead of savings, the government borrows causing national savings to decrease.
Q2. Using a supply and demand diagram, explain how a federal budget surplus could decrease market interest rates and increase private investment.
Reply: The national economy has two sources of demand for funds: private investment and government borrowing. There is no requirement of the government to borrow funds from the credit market when the federal budget is in balance or in surplus. Fig 1 shows the impact of the budget surplus on the credit market. Here i1 is the interest rate at market equilibrium. In the case of federal budget surplus, the government has the option to retire existing debts and thereby increasing the supply of credit from S1 to S2. Thus, retiring debt increase the supply of loanable fund, which in effect causes the market equilibrium interest rate to decline from i1 to i2 (Hyman, 2014). At a lower interest rate, firms and individuals can borrow money more cheaply. The lower cost of loans encourages a higher quantity of borrowing for private investment.
References
Hyman, D.N. (2014). Public Finance: A Contemporary Application of Theory to Policy, 11th Edition. Cengage Learning.
