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U.s. budget deficits/surpluses and private investment

The graph shows that in the case of the United States, since 1980 government borrowing and private investment have often risen and fallen in tandem. The y-axis shows U.S. government deficits/surpluses and private investment as a portion of GDP. The x-axis plots years from 1980 to 2014. It suggests that reduced government borrowing can free up capital for private investment.
The connection between private savings and flows of international capital plays a role in budget deficits and surpluses. Consequently, government borrowing and private investment sometimes rise and fall together. For example, the 1990s show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment.

This argument does not claim that a government's budget deficits will exactly shadow its national rate of private investment; after all, private saving and inflows of foreign financial investment must also be taken into account. In the mid-1980s, for example, government budget deficits increased substantially without a corresponding drop off in private investment. In 2009, nonresidential private fixed investment dropped by $300 billion from its previous level of $1,941 billion in 2008, primarily because, during a recession, firms lack both the funds and the incentive to invest. Investment growth between 2009 and 2014 averaged approximately 5.9% to $2,210.5 billion—only slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94% to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The "crowding out" of private investment due to government borrowing to finance expenditures appears to have been suspended during the Great Recession. However, as the economy improves and interest rates rise, borrowing by the government may potentially create pressure on interest rates.

The interest rate connection

Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? In [link] , the original equilibrium (E 0 ) where the demand curve    (D 0 ) for financial capital intersects with the supply curve    (S 0 ) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D 0 to D 1 . The new equilibrium (E 1 ) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.

Budget deficits and interest rates

The graph plots the downward-sloping demand and upward-sloping supply of financial capital. The y-axis is the interest rate (also known as the “price” of financial capital) and the x-axis shows the quantity of financial capital as a percentage of GDP. An increase in government borrowing increases the quantity of financial capital demanded at all interest rates. This is a rightward shift in the demand for financial capital. The graph shows that the equilibrium interest rate will rise.
In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D 0 to D 1 . As the equilibrium interest rate shifts from E 0 to E 1 , the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.

A survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates. There are, however, economic studies that show a limited connection between the two (at least in the United States), but as the budget deficit grows, the dangers of rising interest rates become more real.

Questions & Answers

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Professor
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The nanotechnology is as new science, to scale nanometric
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nanotechnology is the study, desing, synthesis, manipulation and application of materials and functional systems through control of matter at nanoscale
Damian
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Damian Reply
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Introduction about quantum dots in nanotechnology
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Source:  OpenStax, University of houston downtown: macroeconomics. OpenStax CNX. May 28, 2014 Download for free at http://legacy.cnx.org/content/col11653/1.3
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