Part II Essay and Analysis 55 points 1 A recent WSJ article

Part II - Essay and Analysis (55 points) 1. A recent WSJ article (\"Low Yields H elp U.S. Tame Borrowing Costs\", June 19, 2017, p. B2) exclaimed \"The low yields will benefit the U.s. government, which is planning to sell $1.7 trillion in debt to cover a forecast s1.7 trillion federal deficit in the current year to Sept. 30.\" a.) Explain ceteris pa ribus (i.e., no change in GDP), the impact, if any, such a shift in borrowing costs (if sustained) would have on the size of the total u.s. government budget deficit, the natural employment (structural) deficit, and the cyclical deficit. Be sure to use the so- called Budget Line framework of Gordon Chapter 5 b.) Discuss the effect such a change in borrowing costs would have on the domestic investment, interest rates and foreign borrowing needs of the U.S. Be sure to use the National Savings/Investment framework of Gordon Chapter 5.

Solution

1.a) In this instance,the government decides to sell debt or implement external borrowing to cover the up the concerned federal deficit as given.The increase or expansionary shift in government borrowing ideally leads to contraction or reduction in US budget deficit at least in the short run.Budget deficit is characterized by the gap or difference the government revenue and the government expenditure/expenses for public projects or and public sector ventures in the economy.Hence,the government borrowing would initially reduce the gap between government expenditure and revenue as the borrowed money/funds could be used to finance the deficit assuming that in this case,government expenditure is constant or unchanged.However,if no other additional sources of government revenue can be generated a sustained government borrowing indicates that the US government would now have to periodic interest payment on the bonds issued to repay to the borrowers and this could potentially increase the budgetary expenses thereby again expanding the budget deficit or reducing budget surplus in the long term.Therefore,in the long term high levels of interest and debt payment could offset the revenue generation that is financed by the government borrowing thereby expanding budget deficit.

Now,a sustained government borrowing could potentially accumulate high levels of government debt in the log run and could further expand the budget deficit for longer period of time in future.Therefore,Structural Deficit could persist in the future which is implied by the long term chronological persistence of the Budget deficit.Observe that since the GDP level of the country is constant,persisten government borrowing would expectedly increase the debt-to-GDP ratio in US which would consequently reduce the ability of the government to repay the debt and the interest payment on the borrowing resulting in reduced investor confidence.

Furthermore,continued government borrowing could also potentially expand the Cyclical Deficit in US as increased borrowing and unchanged GDP level in the country would reduce confidence of the private investors which would affect the business activities and production level in the economy thereby causing prolonged recessionary impact. Furthermore,expansion of government debt and budget deficit could imply increased taxes both from households and corporations and reduced government revenue or spending on essential public goods and infrastructure in the country further contributing to recessionary consequences or Cyclical Deficit as this impact could persist if government borrowing is continued to finance federal deficit and if government debt increases relative to GDP growth.Hence,reduction in private investment and business activities would eventually reduce the expansionary impact of fiscal deficit through persistent borrowing.

b) Continued government borrowing by US government could expectedly lead to higher interest rate as through accumulation of debt and higher debt to GDP ratio would cause the interest rate on the government borrowings to increase and higher interest rate would consequently lead to reduction in domestic private investment level in the economy as now businesses and firms would reduce their private borrowings and business investment level which would negatively impact the prouction level in the country and also the savings rate which is essentially determined by the domestic investment level in the economy.Furthermore,sustained government borrowings could induce the crowding out of some of the domestic private investments as many private investors would now provide loans or borrowings to the government instead of deploying capital investment for production purposes and business activities.Additionally,high levels of government debt due to continued borrowing and high debt-GDP ratio could also increase the foreign borrowing by US to finance the investors and borrowers.

c) If the US government fails to show any valid credibility to the investors and borrowers to repay the debt it can possibly affect the currency value of the US Dollars in the f/x market.A potential reduction in debt-GDP ratio could build such positive credibility.Increased and suatained financial borrowing from aborad to finance the borrowing and expanding debt could cause reduction in the value of US Dollar or currency devaluation/depreciation due to continued capital flight by US.Furthermore,if sustained borrowing could lead to inflationary preasures in future as the government could finance the expanding debt level by printing new money or currency(increasing tax being the other possible option) thereby increasing the long term money supply and the inflation rate.Now,inflationary impact could apprehensively lead to currency devaluation or depreciation as well.Now,due to devaluation/depreciation of US Dollar,the US goods and services in the international market would expectedly become relatively cheaper as now the value of dollar has decreased relative other foreign currencies.This would increae the demand for US goods and services in the international market thereby increasing the export volume of the country relative to its overall import volume.As a result,the Net Export which is the difference between Export and Import level of the country would expand in the f/x market.

d) Enhancement in government borrowing or expanding debt-GDP ratio can poosibly compel the government to resort to foreign borrowings to pay the interest payments on borrowing or redeem the government bonds. If budget deficit also potentially expands simultaneously with the sustained government borrowing then such possibility can even expand and hence higher possibility of capital flight to abroad could worsen the economic condition of the country.Now,it is just a possibility as the government can perhaps finaance the debt or the government bonds through increases tax enforcement or money supply by printing.One of the disadvantages of financing debt or borrowing from foreign borrowings is that the it would further expand the debt level of the government and in some occassions it has to be paid in the currency of the lending country leading to some exchange transaction of currencies in the f/x market.