Discuss why a budget deficit results in a different real interest rate under the Ricardo-Barro effect than under the crowding-out effect
What will be an ideal response?
The Ricardo-Barro effect holds that a budget deficit has no effect on real interest rates. A government budget deficit increases the demand for loanable funds. The Ricardo-Barro effect argues that rational taxpayers know that a budget deficit today means higher taxes tomorrow. As a result, taxpayers increase their savings today. The higher private saving increases the supply of loanable funds. Because both the demand for loanable funds and the supply of loanable funds increase by the same amount, there is no change in the real interest rate.
The crowding-out effect holds that a budget deficit increases real interest rates. The crowding-out effect argues that a budget deficit has no effect on the supply of loanable funds. Hence only the demand for loanable funds increases so that the real interest rate rises.
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Psychologists Daniel Kahneman and Amos Tversky conducted the following experiments by asking a sample of people the following questions:
Scenario A: "Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?" Scenario B: "Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket for the play?" As long as additional tickets are available, there's no meaningful difference between losing $10 in cash before buying a ticket, and losing the $10 ticket after buying it. In both cases, you are out $10. Yet, far more subjects (88 percent) in Scenario B say they would pay $10 for another ticket and see the play while in Scenario A, only 46 percent of the subjects say they would be willing to spend another $10 to see the play. Which of the following is the best explanation for the results of the experiment? A) The endowment effect applies in Scenario A since people already own the ticket and therefore it is more valuable but this is not so in Scenario B. B) In Scenario B, people had not anticipated spending an additional $10 so in effect the price of the ticket is $20 and not $10 whereas in Scenario A, the price of the ticket is still $10. C) In Scenario A, people make an immediate connection between the lost ticket and the play and feel poorer by incorrectly assigning a greater value to the value of the ticket whereas in Scenario B, they do not make the connection between the lost $10 bill and the play. D) The net benefit derived from watching the play is lower in Scenario A where the effective cost is $20 compared to the net benefit in Scenario B.