Chapter 18

We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of financial capital. Then:

1. Since the government has a budget surplus, the government budget term appears with the supply of capital. The following shows the national savings and investment identity for this economy.
   $$\begin{array}{rcl}\text{Quantity supplied of financial capital}& \text{ = }& \text{Quantity demanded of financial capital}\\ \text{S + (T – G)}& \text{ = }& \text{I + (X – M)}\end{array}$$
2. Plugging the given values into the identity shown in part (a), we find that (X – M) = 0.
3. Since the government has a budget deficit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade deficit or a trade surplus. But when you see that the quantity demanded of financial capital exceeds the quantity supplied, you know that there must be an additional quantity of financial capital supplied by foreign investors, which means a trade deficit of 2000. This example shows that in this case there is a higher budget deficit, and a higher trade deficit.
   $$\begin{array}{rcl}\text{Quantity supplied of financial capital}& \text{ = }& \text{Quantity demanded of financial capital}\\ \text{S + (M – X)}& \text{ = }& \text{I + (G – T)}\\ \text{4000 + 2000}& \text{ = }& \text{5000 + 1000}\end{array}$$

In this case, the national saving and investment identity is written in this way:

The increase in the government budget surplus and the increase in the trade deficit both increased the supply of financial capital. If investment in physical capital remained unchanged, then private savings must go down, and if savings remained unchanged, then investment must go up. In fact, both effects happened; that is, in the late 1990s, in the U.S. economy, savings declined and investment rose.

Ricardian equivalence means that private saving changes to offset exactly any changes in the government budget. So, if the deficit increases by 20, private saving increases by 20 as well, and the trade deficit and the budget deficit will not change from their original levels. The original national saving and investment identity is written below. Notice that if any change in the (G – T) term is offset by a change in the S term, then the other terms do not change. So if (G – T) rises by 20, then S must also increase by 20.

In the last few decades, spending per student has climbed substantially. However, test scores have fallen over this time. This experience has led a number of experts to argue that the problem is not resources—or is not just resources by itself—but is also a problem of how schools are organized and managed and what incentives they have for success. There are a number of proposals to alter the incentives that schools face, but relatively little hard evidence on what proposals work well. Without trying to evaluate whether these proposals are good or bad ideas, you can just list some of them: testing students regularly; rewarding teachers or schools that perform well on such tests; requiring additional teacher training; allowing students to choose between public schools; allowing teachers and parents to start new schools; giving student “vouchers” that they can use to pay tuition at either public or private schools.

The government can direct government spending to R&D. It can also create tax incentives for business to invest in R&D.