c.31 problem sets

1. What could happen to private savings if the budget surplus increases?

1. it would fall • The national saving and investment identity must always hold true because, by definition, the quantity supplied and quantity demanded in the financial capital market must always be equal.

10. What happens when Americans find U.S. bonds more attractive than foreign bonds as a result of higher interest and exchange rates?

10. Americans supply fewer U.S. dollars. • When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars. U.S. dollar depreciation leads to a larger trade deficit (or reduced surplus).

11. True or false? During the 1990s, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms.

11. True In the late 1990s, for example, the government budget balance turned from deficit to surplus, but the trade deficit remained large and growing. During this time, the inflow of foreign financial investment was supporting a surge of physical capital investment by U.S. firms.

12. Let's say that the U.S. exchange rate appreciates. What would happen to the U.S. supply of dollars?

12. the U.S. supply of dollars would decrease • A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Because of higher interest rates in the United States, Americans find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer foreign bonds, they are supplying fewer U.S. dollars.

13. A budget deficit can easily result in a(n) ___________ exchange rate.

13. stronger • A budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit. A stronger exchange rate makes it more difficult for exporters to sell their goods abroad while making imports cheaper, so a trade deficit (or a reduced trade surplus) results.

14 Which of the following best describes crowding out?

14. high government borrowing, low private investment • When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, economists call the result crowding out. Therefore, high government borrowing and low private investment best describes crowding out.

15. Express what happens to the interest rate equilibrium when foreign investors purchase U.S. government bonds (only shift the aggregate demand curve).

15. • supply decreases • demand increases When foreigners purchase U.S. government bonds, they are increasing their aggregate demand for U.S. financial capital. This shifts the aggregate demand curve to the right, and thus, increases the interest rate equilibrium.

16. Illustrate what happens to the aggregate demand for financial capital when the U.S. government runs a budget deficit.

16. • supply decreases • demand increases When the government borrows, countries who purchase U.S. government bonds increase their demand for U.S. financial capital. This shifts the aggregate demand curve to the right and increases the interest rate.

17. What happened to the "crowding out" of private investment due to government borrowing to finance expenditures during the Great Recession?

17. it was suspended • Investment growth between 2009 and 2014 averaged approximately 5.9% to $2,210.5 billion—only slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94% to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The "crowding out" of private investment due to government borrowing to finance expenditures appears to have been suspended during the Great Recession. However, as the economy improves and interest rates rise, government borrowing may potentially create pressure on interest rates.

18. Demonstrate what happens to the aggregate demand curve when a government's rising budget deficit results in firms being discouraged from making physical capital investments.

18. • demand increases When the interest rate equilibrium increases as a result of a budget deficit, aggregate demand increases and therefore, shifts to the right. A survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments.

19. Demonstrate what happens to the aggregate demand for U.S. financial capital when the interest rate decreases due to a decrease in government borrowing.

19. • demand decreases When the interest rate decreases, there has been a fall in the budget deficit. This implies the government is making more than it spends (or is borrowing less) and so less foreign investors demand U.S. financial capital. This shifts the aggregate demand curve to the left.

2. Which of the following would not occur if the budget deficit fell?

2. foreign investment would rise • A change in any part of the national saving and investment identity by offsetting changes in at least one other part of the equation because we assume that the equality of quantity supplied and quantity demanded always holds. If the government budget deficit changes, then either private saving or investment or the trade balance—or some combination of the three—must change as well. If the budget deficit fell, domestic private investment would rise, or private savings would fall, or trade deficit would fall.

20. Demonstrate what happens to the aggregate demand curve in the following scenario: A government borrows money in effort to alleviate their budget deficit. The central bank reacts by implementing a contractionary fiscal policy, which results in even higher interest rates.

20. • demand increases If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment. Therefore, the aggregate demand curve will shift to the right.

21. An economy is producing near potential GDP, which is threatening an inflationary increase in price levels. Demonstrate what has happened to aggregate demand if the central bank reacts with a contractionary monetary policy.

21. • demand increases If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. Higher budget deficits when the economy is producing near potential GDP increase the risks of dangerous inflation. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.Therefore, the aggregate demand curve shifts right and the interest rate equilibrium increases.

3. If the government runs budget surpluses, which of the following is the correct formula for the national saving and investment identity?

3. Private savings + Trade deficit + Government surplus = Private investment • The U.S. economy has two main sources for financial capital: private savings from inside the U.S. economy and public savings. When the government runs budget surpluses, it acts as a saver rather than a borrower, and supplies rather than demands financial capital. As a result, the national savings and investment identity is:

4. By adjusting the supply and demand curves, demonstrate what happens to the exchange rate between euros and U.S. dollars if there is a trade deficit.

4. • supply increases • demand decreases A trade deficit results from an increase in imports and/or a decrease in exports. This means that more foreign currency is demanded (in exchange for dollars) - this is an increase in dollar supply. Additionally, fewer dollars are demanded due to the decrease in export demand - this is a decrease in dollar demand. Therefore, a trade deficit results in a cheaper dollar.

5. Demonstrate what happens to demand for U.S. currency when there is an inflow of foreign financial capital.

5. • demand increases A budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors.

6. How does a budget deficit impact demand in market for domestic financial capital?

6. it increases the demand • A budget deficit increases demand in markets for domestic financial capital, which raises the domestic interest rate. As a result, a higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for dollars by foreign investors and a decrease in supply of domestic dollars.

7. What would economists describe as the "twin deficits?"

7. government budget and trade deficits • In the mid-1980s, it was common to hear economists and even newspaper articles refer to the twin deficits, as the budget deficit and trade deficit both grew substantially.

8. Illustrate what happens to both the demand and the supply of dollars if the domestic interest rate increases.

8. • supply decreases • demand increases A budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars. Hence, the exchange rate strengthens.

9. Demonstrate how the equilibrium exchange rate is impacted when there are higher domestic interest rates and an increased inflow of foreign investment capital.

9. • supply decreases • demand increases A budget deficit can easily result in an inflow of foreign financial capital, a stronger exchange rate, and a trade deficit. You can also imagine interest rates are driving the exchange rate appreciation. A budget deficit increases demand in markets for domestic financial capital, raising the domestic interest rate. A higher interest rate will attract an inflow of foreign financial capital, and appreciate the exchange rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease in supply of U. S. dollars.