Answer to Question #176925 in Macroeconomics for Wilson

Question

a) Suppose government moves from a balanced budget to a budget deficit. Use the loanable funds market to explain what happens to the rate of interest, private investment spending, private saving, private consumption spending, public saving and national saving.

b) Explain using diagrams what happens to the rate of interest, consumption, investment, and aggregate demand if the Central Bank sells government bonds to the public.

Answer 1

a)

Monetary emission can be non-inflationary only at significant rates of economic growth since the growing economic activity is accompanied by an increase in demand for money, which absorbs part of the additional money supply. But at the same time, the influence of such factors as inflationary expectations, the size of the monetary base, and the preferences of economic agents are of great importance.

In general, monetization can be used as a way to solve the problem of the state budget deficit. However, it must be borne in mind that this is an economically unsafe way. It is usually used by national governments in exceptional cases when, for example:

1) there is a significant external debt, which excludes concessional financing of the budget deficit from external sources;

2) the possibilities of domestic debt financing are practically exhausted;

3) the foreign exchange reserves of the Central Bank are depleted, due to which the regulation of the balance of payments remains a paramount task;

4) the economy is able to withstand high inflation, and citizens are already accustomed to the constant rise in prices.

If the government nevertheless chooses the emission method of budget financing, then the Central Bank must first all introduce restrictions (limits) on lending to state-owned enterprises and organizations. Otherwise, there may be a risk of complete crowding out of the private sector from the credit market and a drop in investment activity. It is also necessary to constantly keep under control the level of inflation, to monitor the state of the balance of payments.

A less painful and more manageable way of solving the problem of the state budget deficit is debt financing. As a result of debt financing, the budget deficit is covered by loans provided by the state both within the country and abroad. On the basis of this, the external and internal debt of the state is formed.

Different branches of economic thought have different attitudes towards debt financing. So, representatives of the neoclassical direction, starting with A. Smith, have a negative attitude towards debt financing. They believe that A. Smith was right when he said that deficit financing is "a one-way street, once entered, you cannot turn back." As a result of debt financing, the wealth of the nation decreases the tax burden increases, which hinders the accumulation of capital.

b)