Question

Determine if each statement is true or false. 1. An increase in government transfer payments can crowd out private investment. 2. An improvement in the budget balance increases the demand for financial capital. 3. An increase in private consumption may crowd out private investment. 4. Lower interest rates can lead to private investment being crowded out. 5. An improvement in the trade balance must come from an increase in national savings. 6. For an open economy, if private savings is equal to private investment, then there is neither a budget surplus nor a budget deficit.

Answer 1

Answer:

1. True.

2. False.

3. True.

4. False.

5. False.

6. False.

Explanation:

1. True. An increase in government transfer payments can crowd out private investment in two ways. On the one hand, the state provision of goods and services (which is the purpose of transfers) subtracts commercial opportunities from the private sector. For example, the creation of a free health-care system or public education reduces the scope of action for the private sector.

The other way is more complex and has to do with financing. To pay for the increase in transfer payments (and in general all its activities) the government uses three sources: taxes, debt and inflation. If corporate taxes increase, then, companies will have less incentive to develop productive projects, which would crowd out private investment. On the other hand, if the government becomes heavily indebted, it will resort to the private sector to request credit, thereby hoarding much of it and expelling other credit demandants (such as businesses and households). Likewise, this will generate an over demand for credit that will boost interest rates upwards, so that entrepreneurs will refrain from starting new projects, that is, there will be a crowding-out in private investment.

2. False. This can be demonstrated by analyzing the following equation:

Demand for financial capital = I+(G-T)

Where I is investment, G is public spending and T are taxes. Therefore (G-T) is the budget balance.

An improvement in the budget balance means that taxes (government revenue) tend to be larger than public spending (expenses). So as the magnitude of T increases in the equation, the demand for financial capital will decrease. Let's prove it with a simple numerical example.

Suppose that initially, I=1000, G=300 and T=10 0.

Demand for financial capital = 1000+(300-100)

Demand for financial capital = 1200

Now, suppose investment and spending remain constant, but taxes increase to 400 (an improvement in the budget balance).

New demand for financial capital = 1000+(300-400)

New demand for financial capital = 900

Theoretically, that means that the government has reduced its pressure on the credit sector, because it no longer needs as many funds as before,  so the demand for financial capital has been reduced (by $300 in our example).

3. True. An increase in consumption means that individuals will allocate most of their income to the purchase of goods and services, rather than saving. Due to this reduction in savings, the supply of the loanable funds market will also do so, which in turn raises interest rates, and with higher interest rates, the incentives of firms to invest decrease, which ends up crowding out private investment.

4. False. In the market of loanable funds, the supply is made up of the savings that the economic agents deposit in the banks, and the demand is made up of all the borrowing requests of households and firms. In turn, the price of this market is the interest rate. When it is low, it means that the price of credit has decreased, which will make firms have incentives to demand more of it, and with these resources they can carry out new capital investments.

5. False. The trade balance depends not only on national savings (public savings + private savings) but also on domestic investment "I". Therefore, an improvement in the trade balance should not necessarily be linked to an increase in national savings. Let us demonstrate it with an example (from the trade surplus equation):

$TS=S+(T-G)-I$

Where S = private savings, (T-G) = public savings and I= investment

Let us suppose:

$TS=1000+200-100$

$=1100$

With an increase in national savings:

$TS=2000+300-100$

$TS=2200$

Although the trade balance improves, this situation can also occur with a decrease in investment, maintaining the original amount of national savings:

$TS=1000+200-10$

$TS=1190$

6. False.

First, the statement presents a very important theoretical failure: In an open economy, investment is not equal to savings (I = S), but is equal to savings plus external capital flows. Formally it would be represented as follows:

Investment = Private savings + Public savings + Capital inflows (CI).

Here "public savings" can take any value and theoretically will not affect the equality, there may be a deficit (negative public savings), a surplus (positive public savings) or neither one nor the other, as the question raises, in which case it would be 0. This last condition may occur, but that does not mean that the equality (I=S+CI) depends on it.