Key Concepts and Summary

17.1 How Government Borrowing Affects Investment and the Trade Balance

A change in any part of the national saving and investment identity suggests that if the government budget deficit changes, then either private savings, private investment in physical capital, or the trade balance—or some combination of the three—must change as well.

17.2 Fiscal Policy, Investment, and Economic Growth

Economic growth comes from a combination of investment in physical capital, human capital, and technology. Government borrowing can crowd out private-sector investment in physical capital, but fiscal policy can also increase investment in publicly owned physical capital, human capital (education), and R&D. Possible methods for improving education and society’s investment in human capital include spending more money on teachers and other educational resources, and reorganizing the education system to provide greater incentives for success. Methods for increasing R&D spending to generate new technology include direct government spending on R&D and tax incentives for businesses to conduct additional R&D.

17.3 How Government Borrowing Affects Private Saving

The theory of Ricardian equivalence holds that changes in government borrowing or saving are offset by changes in private saving. Thus, higher budget deficits are offset by greater private saving, whereas larger budget surpluses are offset by greater private borrowing. If the theory holds true, then changes in government borrowing or saving have no effect on private investment in physical capital or on the trade balance. However, empirical evidence suggests the theory holds true only partially.

17.4 Fiscal Policy and the Trade Balance

The government need not balance its budget every year. However, a sustained pattern of large budget deficits over time risks causing several negative macroeconomic outcomes: a shift to the right in aggregate demand that causes an inflationary increase in the price level; crowding out of private investment in physical capital in a way that slows down economic growth; and the creation of a dependence on inflows of international portfolio investment, which can sometimes turn into outflows of foreign financial investment that can be injurious to a macroeconomy.