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International Capital Markets

International Capital Markets - Government Saving The...

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International Capital Markets From Last Time Expected profitability of capital and the expected real interest rate are two of the factors that influence the amount of business investment. Any price change (and the interest rate is the price of borrowing money) has two effects: the substitution effect and the income effect. The substitution effect comes about because a rise in the interest rate increases the rewards to saving. So, pe ople save more and spend less. However, the income effect has the opposite effect. A rise in the interest rate means I need to save less to reach a given savings goal because what I do save will earn more interest. Studies have found the substitution e ffect is strong: a rise in the interest rate increase savings.
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Unformatted text preview: Government Saving The government is a net saver when it runs a budget surplus; it is a net borrower when it runs a budget deficit. A government budget deficit reduces the pool of savings available for private borrowing. This decrease in savings raises the interest rate. However, interest rates will not be affected if Ricardian Equivalence holds. Ricardian Equivalence is the proposition that private savings rises to offset government budget deficits. Households realize that budget deficits must be financed by higher taxes in the future. Household savings will rise in order to have the funds available to pay these higher taxes. The savings curve does not shift. Empirically, however, there is little support for Ricardian Equivalence....
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