CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 569
billion to $1,600 billion. That is, the shift in the supply curve moves the market
equilibrium along the demand curve. With a lower cost of borrowing, households
and firms are motivated to borrow more to finance greater investment. Thus, if a
change in the tax laws encouraged greater saving, the result would be lower interest rates
and greater investment.
Although this analysis of the effects of increased saving is widely accepted
among economists, there is less consensus about what kinds of tax changes should
be enacted. Many economists endorse tax reform aimed at increasing saving in or-
der to stimulate investment and growth. Yet others are skeptical that these tax
changes would have much effect on national saving. These skeptics also doubt the
equity of the proposed reforms. They argue that, in many cases, the benefits of the
tax changes would accrue primarily to the wealthy, who are least in need of tax re-
lief. We examine this debate more fully in the final chapter of this book.
POLICY 2: TAXES AND INVESTMENT
Suppose that Congress passed a law giving a tax reduction to any firm building a
new factory. In essence, this is what Congress does when it institutes an investment
tax credit, which it does from time to time. Let’s consider the effect of such a law on
the market for loanable funds, as illustrated in Figure 25-3.
First, would the law affect supply or demand? Because the tax credit would
reward firms that borrow and invest in new capital, it would alter investment at
any given interest rate and, thereby, change the demand for loanable funds. By
contrast, because the tax credit would not affect the amount that households save
at any given interest rate, it would not affect the supply of loanable funds.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
4%
5%

Americans to save more would
shift the supply of loanable funds
to the right from S
1
to S
2
. As a
result, the equilibrium interest
rate would fall, and the lower
interest rate would stimulate
investment. Here the equilibrium
interest rate falls from 5 percent
to 4 percent, and the equilibrium
quantity of loanable funds saved
and invested rises from $1,200
billion to $1,600 billion.
570 PART NINE THE REAL ECONOMY IN THE LONG RUN
Second, which way would the demand curve shift? Because firms would have
an incentive to increase investment at any interest rate, the quantity of loanable
funds demanded would be higher at any given interest rate. Thus, the demand
curve for loanable funds would move to the right, as shown by the shift from D
1
to
D
2
in the figure.
Third, consider how the equilibrium would change. In Figure 25-3, the in-
creased demand for loanable funds raises the interest rate from 5 percent to 6 per-
cent, and the higher interest rate in turn increases the quantity of loanable funds
supplied from $1,200 billion to $1,400 billion, as households respond by increasing

3. ...and raises the equilibrium
quantity of loanable funds.
Supply
Demand,
D
1

D
2
Figure 25-3
A
N
I
NCREASE IN THE
D
EMAND
FOR
L
OANABLE
F
UNDS
. If the
passage of an investment tax
credit encouraged U.S. firms
to invest more, the demand for
loanable funds would increase.
As a result, the equilibrium
interest rate would rise, and
the higher interest rate would
stimulate saving. Here, when the

Third, we can compare the old and new equilibria. In the figure, when the
budget deficit reduces the supply of loanable funds, the interest rate rises from
5 percent to 6 percent. This higher interest rate then alters the behavior of the
households and firms that participate in the loan market. In particular, many
demanders of loanable funds are discouraged by the higher interest rate. Fewer
families buy new homes, and fewer firms choose to build new factories. The fall in
investment because of government borrowing is called crowding out and is repre-
sented in the figure by the movement along the demand curve from a quantity of
$1,200 billion in loanable funds to a quantity of $800 billion. That is, when the gov-
ernment borrows to finance its budget deficit, it crowds out private borrowers
who are trying to finance investment.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
$800 $1,200
3. ...and reduces the equilibrium
quantity of loanable funds.
S
2
2. ...which
raises the
equilibrium
interest rate...
Supply,
S
1
Demand
5%

1
to S
2
, the equilibrium
interest rate rises from 5 percent
to 6 percent, and the equilibrium
quantity of loanable funds saved
and invested falls from $1,200
billion to $800 billion.
crowding out
a decrease in investment that results
from government borrowing
572 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY
THE DEBATE OVER THE BUDGET SURPLUS
Our analysis shows why, other things being the same, budget surpluses are bet-
ter for economic growth than budget deficits. Making economic policy, how-
ever, is not as simple as this observation may make it sound. A good example
occurred in the late 1990s, when the U.S. government found itself with a budget
surplus, and much debate centered on what to do with it.
Many policymakers favored leaving the budget surplus alone, rather than
dissipating it with a spending increase or tax cut. They based their conclusion
on the analysis we have just seen: Using the surplus to retire some of the gov-
ernment debt would stimulate private investment and economic growth.
Other policymakers took a different view. Some thought the surplus should
be used to increase government spending on infrastructure and education be-
cause, they argued, the return to these public investments is greater than the
typical return to private investment. Some thought taxes should be cut, arguing
that lower tax rates would distort decisionmaking less and lead to a more effi-
cient allocation of resources; they also cautioned that without such a tax cut,

The behavior of the debt–GDP ratio is one gauge of what’s happening with
the government’s finances. Because GDP is a rough measure of the govern-
ment’s tax base, a declining debt–GDP ratio indicates that the government in-
debtedness is shrinking relative to its ability to raise tax revenue. This suggests
that the government is, in some sense, living within its means. By contrast, a ris-
ing debt–GDP ratio means that the government indebtedness is increasing rela-
tive to its ability to raise tax revenue. It is often interpreted as meaning that
fiscal policy—government spending and taxes—cannot be sustained forever at
current levels.
Throughout history, the primary cause of fluctuations in government
debt is war. When wars occur, government spending on national defense rises
Percent
of GDP
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990
Revolutionary
War
2010
Civil
War
World War I
World War II
0
20
40
60
80
100
120
Figure 25-5
T