Question

Compared to \(£ 52\) million for 6,574 students in \(2010,\) around 53,000 students received about \(£ 675\) million a year in \(2013-14\) in the form of student loans from the state. a. How do state loans influence the government's budget? b. If there is a budget deficit, how would you expect it to influence the demand for loanable funds and the equilibrium real interest rate?

Short answer

State loans increase government expenditure, potentially causing a budget deficit. This leads to higher demand for loanable funds and increases the equilibrium real interest rate.

Step-by-step solution

- Analysis of State Loans and Government Budget

State loans mean that the government is providing financial support to students. This support is often not immediately repaid, which constitutes an expense for the government. Thus, student loans negatively influence the government's budget by increasing government expenditure.

- Understanding Budget Deficit

A budget deficit occurs when the government's expenditures exceed its revenues. In this scenario, providing student loans without an immediate corresponding income would contribute to a larger budget deficit.

- Impact on Demand for Loanable Funds

With a budget deficit, the government might need to borrow more money to cover its expenditures. This increased borrowing would raise the demand for loanable funds in the financial markets.

- Effect on Equilibrium Real Interest Rate

The increased demand for loanable funds drives up the equilibrium real interest rate. When the government borrows more, the competition for available funds increases, leading to higher interest rates.

Key concepts

Budget Deficit

A budget deficit happens when a government spends more money than it brings in through income, like taxes. Put simply, if a government has more bills to pay than the money it collects, it runs into a budget deficit.

When a state issues student loans, it’s using its money to provide financial aid. This money is often not paid back right away. Hence, even though providing loans is an investment in the future workforce, it also adds to the current expenses. So, if the government already spends a lot, giving out student loans will make the budget deficit even larger.

In other terms, student loans take away money that's immediately available for other government needs. This could mean the government will have to find other ways, such as borrowing more, to balance out its budget.

Loanable Funds

Loanable funds are the money available in financial markets that can be lent out to borrowers. Think of it like a pool of money that borrowers can dip into for their needs, be it individuals, companies, or governments.

When there's a budget deficit, the government may need to borrow more money to cover its expenses. This means the government will tap into these loanable funds. Now, the more the government borrows, the less there is available for everyone else. This raised demand from the government can cause a shift in the loanable funds market.

In summary, a budget deficit increases the government’s borrowing needs, thus increasing the overall demand for loanable funds in the market.

Real Interest Rate

The real interest rate is essentially the cost of borrowing money, adjusted for inflation. It’s what lenders use to decide how much interest to charge borrowers, reflecting the true economic cost of the loan.

When the government borrows more money due to a budget deficit, it raises the demand for available funds in the financial markets. With more competition for the same amount of money, lenders can charge higher interest rates.

This means the equilibrium real interest rate will rise. Higher real interest rates affect everyone who needs to borrow money because they’ll end up paying more in interest overall.

Government Expenditure

Government expenditure is what the government spends on goods, services, and financial support like student loans. This includes spending on public services such as education, healthcare, and infrastructure.

When the state gives out student loans, it’s allocating money for students’ education. While this can be viewed as a positive investment, it is also a significant expense. This increased expenditure can expand the budget deficit if it exceeds the government’s revenue.

Enhanced government spending on any form of aid, including student loans, adds to the overall financial burden. The money has to be managed wisely to avoid escalating deficits, and understand how this spending influences overall economic dynamics like loanable funds and real interest rates.