Archive for the 'Loanable Funds Market' Category

Feb 14 2009

Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?

CBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation

The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the short-run and long-run macroeconomic effects of the House Stimulus Package.

It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:

CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…

Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.

In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt.  To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.

The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.

  • The nation’s potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
  • Fiscal stimulus’ effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
  • A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.

I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.

I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.

This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.

To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

This passage from the director’s letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.

Discussion questions:

  1. In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
  2. Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
  3. Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.

200 responses so far

Apr 26 2008

From the Help Desk – more on loanable funds and the money market

Carmen submitted the following through the “Econ Help Desk

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

11 responses so far

May 22 2007

2007 AP FRQ #2 – Tax credits and the loanable funds market

Molly Saso, AP Econ teacher at the International School of the Sacred Heart in Tokyo, asked in an email to the AP Econ email list about Free Response Question #2 from the International exam (form B). The question reads:

2. (a) Assume that businesses are granted a tax credit on spending for machinery. Using a correctly labeled graph of the loanable funds market, show the effect of the business sector’s response on the real interest rate.

Here’s Molly’s email:

“The loanable funds market, in spite of its apparent simplicity, continues to throw up some ambiguities–or perhaps it’s just me who is perplexed.

What would be the impact on the market of a tax credit for spending on machinery? (Q2 on Form B, 2007–all the FRQs are already on AP Central.)

While the intent is indeed to increase planned investment, would firms increase or decrease their demand for loanable funds? To the extent that the tax credit means that there is a greater amount of post-tax profits available for investment, then the demand for loanable funds could decrease; but wouldn’t many firms need to supplement their post-tax profits with a greater demand for loanable funds?

Perhaps, if the impact on demand is indeterminate, the shift would be in supply, since firms would have a greater store of “savings” (retained profits). However, since a shift in supply was the answer to the second part of Q2, I somehow doubt that the examininer would be expecting a supply shift in part (a) as well.

The trouble is that the question asked for no explanation–only a graph to “show the effect”. I wonder what kind of shift was expected?

In perplexity,
Molly”

Molly’s question is a good one, and although I hadn’t spent much time reflecting on this question, her email got me thinking more about this interesting and challenging question. Here’s what I came up with and replied to Molly with. I don’t know if it’s correct or not, but I’d be interested to hear what others thought about this question:

Hi Molly,I’m in Shanghai, so my students also took form B (the international questions). I too found this to be a bit confusing. But as I teach my students, “don’t make the questions more complicated than they have to be, look for the most obvious answer.” Unfortunately, this one had no immediately obvious answer, as you explain below. I think what made it difficult was the term “tax credit on spending for machinery”. I don’t know about you, but this specific term never came up in my class!

Here’s how the question begins: “Assume that businesses are granted a tax credit on spending for machinery”. I interpret this tax credit as an amount deducted from federal income tax, calculated as a fixed percentage of expenditures on, in this case, machinery. In other words, the tax credit is not granted unless the firm undertake investments in new machinery. Your suggestion that the tax credit results in a “greater amount of post-tax profits available for investment” may be mistaking the credit indicated with a reduction in corporate profit taxes. I think if this were a corporate profit tax question then perhaps demand for loanable funds would go down since new investment could come from the now higher profit margins firms receive; in fact, the tax credit is not granted until new investment is undertaken by the firms in the first place.

I would explain this to my students by saying that essentially, the expected rate of return on investments goes up (since fewer taxes will be paid once new machinery is bought), shifting the Investment Demand curve out, thus the Demand for loanable funds, increasing the real interest rate.

That said, I cannot be certain that this is what the AP was looking for, so don’t hold me to it! Writing this email allowed me to really clear this one up, though, so thanks for the inquiry!

Jason

Anyone else have a better answer or something to add?

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