Government Loan and Guarantee Programs - St. Louis Fed

Government Loan and GuaranteeProgramsJOEL FRIED

HE U.S. government is involved heavily in pro-viding credit assistance to the private sector. From1971 to 1981, the total amount of federally assistedcredit outstanding jumped from $217 billion to $678billion, an increase of over 200 percent.’ Moreover,government direct and guaranteed loans constitutedalmost 12.5 percent ofthe total hinds advanced, direct-ly or indirectly, to the non-federal sector over theperiod 1972—81. In 1980 and 1981, the proportion ofnew funds loaned to the non-federal sector in the formof a government direct loan or guarantee rose to 17percent.2

This article examines the consequences ofdirect andguaranteed loan programs on interest rates and aggre-gate demand. The analysis focuses on shifts in thesupply and demand schedules for alternative sourcesofcredit affected by each type of pi-ogram. The resultsindicate, under fairly standard assumptions, that anincrease in government direct loan programs accompa-nied by an equal decrease in government-guaranteedloan programs will decrease loan rates to borrowerswho are ineligible for credit assistance. This shift inloan assistance also will increase the rate of interest on

Joel Fried is an associate professor of economics at the Unirersity ofWestern Ontario. This article was written while Professor Friedwas a visiting scholar at the Federal Reserve Bank of St. Louis,Thomas H. Gregorsj provided research assistance.

‘See The Budget of the United States Government, 1983,SpecialAnalysis F, Federal Credit Programs (Washington, DC., 1982).This credit assistance consists of direct government loans, loangnarantccs and loans by government—sponsored enterprises.

2These data are calculated from Ibid.. table F—i, p. 6. It exclndesneW equity financing.

government debt, and will increase the demand priceof capital and level of aggregate demand.

GOVERNME.NT LOAN PROGRAMSANI) PORTFOLIO CHOICE

There are two major mechanisms by which the gov-ernment provides credit to private individuals throughcapital markets: guaranteed loans and direct loans.3 Inthe former, the government, having designated thepotential recipients, guarantees loans made to thisgroup by private financial intermediaries (hereafterreferred to as banks) against any default. In a competi-tive banking environment, banks will pass on the eco-nomic value of the guarantee to the borrower. As aresult, the borrower obtains the loan at a lower ratethan the hank would have charged without the govern-ment guarantee.4

In the case ofdirect loans, a government agency actsas an intermediary in place of banks; it issues loansdirectly to the targeted group, obtaining the necessary

i’his does not exhaust the forms of government capital marketintervention, Other programs affecting capital nsarkets that havecome under the scrutiny of the Treasury its receost years includelending by government—sponsored enterprises and tax exemptionsfor interest income on some types of loans. These are not cots—sidcrcd in this paper.

5This subsidy need not he restricted to tlse actuarially isir value ofthe insurance. The government also could charge the banks afeefor the provision ofthe insurance Or could prox’ide a cash subsidy inaddition to tlse guarantee if. fbr some reason. it wished the efl’ectivesubsidy rate to he clilkrent froas the expected defitult rate,

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FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1983

Table 1Direct Loan Transactions of the Federal Government:1982 Fiscal Year (millions of dollars)

Net Outlays Outstandings

On-Budget Agencies

Funds approoriated to the P’esraent S 777 $ 17.932Agriculture 6.164 31.186Commerce 104 891Eaucation 641 9.859Energy 4 13Health programs 9 921Housing and tJrbar Development 351 13.216tnter,or 1 441Transportation 86 1.003Veterans Adminstratiun 228 3.368L.oans to me District o! ~okjrnbia 17 1.684Export-Impon Bank 763 16.565Federal Deposit Insurance ~o’poralion 274 705Foaorat Home L.oari Balk Board 86 758Natonal Creoit Union Mm nstration .34 149Srria!! Busness Administration 22 9.169Tennessee Va

1ey Aulnor:ty 69 267

Other agences and programs , 224 —. 1.091

Subtota. on-budget agencies 9 10? 100.220

Oft-Budget Federal Entities

Rural Etectrticatron ano leiephone Revoivino Fund .5 130 $ 9.7/4Rural ~eleprione Bank 102 1 73Federal F.nani iri9 Bark iFFB~ 14 ‘55 96519

U S Ratway Associanor 42 123

Subtota’. off-bjccet4

ederal en!it:es 14.345 107 588

TOTAL, net d:rect ioans 523.452 5207 808

SOURCE Ottice of Management aid B~oget-Spetn/ Analyses. Budget of the Unted.S’tates Govern.inert Fiscal Yea, 7984 ti S Govnr.mert Prir.tnq O

tSce. 1983, Tahe F-6

funds from the capital markets by issuing Treasurysecurities. Because government securities are used toraise the funds, the interest cost will be lower than onfunds raised by private institutions. If the governmentintermediary passes on this reduction, the borrowerwill obtain a subsidized rate of interest on his loan.5

‘The ssihsidy here refei’s to tlse difference between tlse rate ofintei’cst a horrower would pa\’ if tise luass were nhtained frons a hankand the sate he would pay under either tIme loan guarantee Or directhsan prngra~sss of the governsn emit, Tim is ma\ not correspond to thesubsidy as viewed by tIme taxpayer; tlsat is, the eQst of tIme loan lessthe i’atc of iis terest pmci on time bass, Rot gls estimates of the

ihsidies invol s’ed in thc’ various government loan assd guarantec’programs are pi’esented iss Special Analysis F, Federal CreditPrograms, 1982. See, especially, tables F’— 11 A and F—ilB.

Tables 1 and 2 present the various direct loan andguarantee programs that existed in the 1982 fiscal year.As the tables show, virtually every sector of the econ-omy is covered by some type of program, and assis-tance to some sectors takes the form of both directloans and guaranteed loans. For instance, of the $9,943million loans and guarantees outstanding in 1982 forthe Farmers Home Administration’s program for ruraldevelopment, $153 million was on-budget directloans, $3,387 million was ofihudget direct loansthrough the Federal Finance Bank (FFB) and $6,403million was provided through govermnent guarantees.Indeed, the FFB holdings of loans guaranteed by avariety of on- and off-budget agencies provides anespecially convenient mechanism to convert loanguarantees into direct loans. ‘[lie FFB simply pur-

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Table 2Gbaran eed Loan Transactions *t the ffed~tat<k$erflmen1*ZFIs$~t$sOllars) /,_,,--~

Loans-~

f ~ppmpnats& fl$t Pte~tdtht $2 $Agticultu a

Pggmmievet &3*Gus 443

Qttmmerce \-

NathnMOcean and Mmosptie \ASm$SSe, a

83belense Md~a~S Humflr

lnteSr ~i~a8~podal1~n

N-

uaw~s nfl SateSeransA4muistrt lHausm

N-ffitlOnal ttMSAdrnjsflt~m 2— Støti Vfley*tgSnwahecag~ann flr*ms __

Less Setondery atarstejed ioar$c6NMAguaan$~s EN m8AjeS Oat _____

SbtOtSIS tkatn mt~ M 0 31 89

Less 9uatanteedtestis hekI as rectittansby budGetagency MA 4t611byaWbud,qst tat t inflatik 4 ____

TOTAL, pray .gtwratsed tflaes $2U$S~

nsa,Sranteesjbythe port lnipoa~ank thedebtatijiep rvateE portruianceGoiporattonhave not*een estinr*tt m .eiflidedtan the able

hen~uaranteedIoartSaracpteedbya budgetacco in theybecome tSk*naattd e untedeasud’t inlabia I they at the Mote dethsctedtorn the tot~jnthis table

SOURO Oteot Managemrtsn aM BudgetSpiSlAnS* BudgetMIte llmtedmeat $ Yes ~84 ~ Government Pnntmg Office, 983) Table

chases the guaranteed loans that would otherwise have Gov ‘rnmcnt loans and guarantees embrace a varietybeen sold to private banks.6 of programs none of which is of specific interest here.

Thus, the subsequent analysis assumes that recipientstlt also should h noted that the distinction hctssei n on budgetand off budget direct loans is ri_ails onl~ in accounting distine- on budget drect loans the funds ‘ire aiboeated by the Tre i rs

tion. ‘set new drc et loans i sued h, on budget agencies are treated directly to the sg ncs in the cas nf FFB direct lc’nding the F 113as part of the budget. an increase of Si million in these loans hows draw on its line of credit at th’ lreasurs amid the Trea ury thenup as an incr is’ of 3i million ia the hudget dc fleit. An increase of issu ‘s debt to pro’ id’ the F F B with the funds This accountin,,the same amount in off budget FF13 direct loan. wouldsot sncrc’msc convention while pethaps important for congrcs ional control hasthe deficit. Both will do precmseis the same thing to the goserument no op ~rationii meaning for the ssne consid red here anddebt however namel~increase it hi, Si mullion. In the else of ignored.

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of government direct loans or guarantees are drawnrandomly from the general population. Our focus is onthe effect of moving a preselected group of individualsfrom one type of program to the other, without regardto the specific program itself.’

The principal difference between the governmentdirect loan and guarantee programs lies in the port-folios that households and banks must hold as a result ofthese programs. For a given level of total governmentcredit provided, an increase in the number of directloans granted will increase the amount of governmentsecurities that must be held by either banks or house-holds. Therefore, a general model of portfolio choice isnecessary to trace the effects of differential changes inthe two programs. In this article, the analysis is de-rived from the implications of a formal model based onthe work of James Tobin and detailed elsewhere.8

To present the model, the credit market is firstdescribed for the case in which no government creditprograms exist; then the innpacts of introducing first aguarantee program and then a direct loan program areexamined. Having examined the impact of each pro-gram separately, the differential impact of the twoprograms on interest rates and aggregate demand canthen be assessed.

THE MARKET FOR THESTOCK OF CREDIT

Suppose there are no government direct loan orguarantee programs. The market for credit then ischaracterized in figure 1. D0 describes the demand forloans by the private sector and is a function not only ofthe loan rate, R9, hut also of rates of return on capitalgoods arid on government securities, An increase inthe loan rate decreases the quantity of credit de-

7The choice of program amid recipient is, however, important inconsidering the impact of increases in total federal credit assis-tance. The answer to the question of whether such increases wouldincrease the welfare of society hinges on whether the new assis-tance decreased differences us the social amid private marginalbenefits ofcredit to the recipient. The assumption that recipientsare chosen randomly would he inappropriate for such an analysis.Therefore, this question is not addressed in this arlicle.

tSee Joel Fried, “Government Direct Loans and Loan GuaranteePs’ogramns; A Formal Analysis,’’ Federal Reserve Batik of St. LouisWorking Paper #83-017, Octoher 1983. This analysis modifies theframnework presented ha’ James Tohin, “A General EquilihriusnApproach to Monetary i’lieory,” Jounmal of Money, Credit andBanking (February 1969). pp. 15—29, to incorpos’ate the two typesof government credit assistance.

Figure 5

The Loan Market, Excluding Government Loan Programs

Loan rateof interest

The credit supply curve ofbanks is described by theupward sloping line 5o~By assumption, it is positivelysloped to reflect the increasing marginal costs of lend-ing. These costs consist of the operating costs of thebank loan department and the cost of obtaining fundsto lend, either by attracting more deposits or by sellinggovernment securities from the bank’s portfolio’0 Anincrease in the rate ofreturn on any other asset that thebank could hold would shift the supply curve for creditup, as would an increase in the rate of interest ondeposits. As drawnin figure 1, the equilibrium level ofcredit is L0 and the equilibrium rate of interest on it is11,0.

°Inprinciple, at least, increases in the rate ofreturn on any asset willincrease the demand for credit as the household reshuffles itsentire porffolio to take advantage ofthis higher return, In practice,it cast he expected that increases in R, will alter credit demandmore thasm would an equal increase is) 11. or R,m. l’his is becausehouseholds generally do not borrow to purchase assets that yieldpecuniary’ returns lower than the loan rate.tm0rhe analysis in Fried, Government Direct Loans (see equation

i—3) supposes that government securities, like ‘nones’, can heviewed as a” producer’s good” that facilitates exchange activity.See also Joel Fried and Peter Howitt, ‘‘The Effects of Inflation On

Real Interest Rates,” American Economic Review (December1983). pp. 968—80, for a more detailed presentatiosm of this view.

manded; increases in rates of return on other assetsshift the demand curve out.°

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introducing a Government-GuaranteedLoan Program

Now suppose the government institutes a govern-ment guarantee program that is available only to aportion of the population.1’ Figure 2 shows the conse-quences of this program in the credit market. Forcomparison, D0 and S~are the same as in figure 1. D,describes the demand for loanable funds by all poten-tial borrowers who are not eligible for government-guaranteed loans.

To establish the effects of the guarantee program,some assumptions about the relationship between therate ofinterest on loans that do not have a governmentguarantee, 11,, and on those that do have the guaran-tee, R~,must be made. We shall assume that thegovernment wants to provide preferred borrowers afixed subsidy rate, 5, per dollar of loan, and that thebanking system is sufficiently competitive that, at themargin, the profit rates on guaranteed and non-guaranteed loans are equalized.’2 Thus,

(1) Rgg = 119 — S.

Figure 2

The Loan Market, Including Government Guaranteed Loans


R

Under this assumption, changes in S cause the totaldemand for credit, as a function of R~,to shift; as S isincreased, individuals eligible for government-guaran-teed loans would increase their demand for credit atany given H,. Thus, for a positive subsidy rate, creditdemand would be greater than it otherwise would bewithout the guarantee program. D2 in figure 2 de-

“As mentioned eadier, it is supposed that those eligible for thegovernment programs are chosen randomly from the populationat large. This assumption is not meant to deny one rationale oftengiven for government credit assistance programs, namely, thatthese are set up to provide funds to high-risk individuals andinstitutions. Rather, it is to clarift the exposition ofthe financingeffects of the direct loan and guarantee programs, which is ourprimary concern, If this assumption is not made, then the loansupply schedule ofbanks would depend on how the favored groupwas chosen, If the government could identify the high-risk bor-rowers in the economy and provide them with guarantees ordirect loans, then the snmpply cun’e ofloans by banks to uninsuredborrowers. ceteris paribus, would most likely shift omst with theestablishment of the government programs.

‘2Suppose hanks initially’ did not pass on these reduced costs to theborrower. Then, D, svould continue to describe the total demandfor credit. Each hank, however, would have an incentive to ofier alower rate to insured borrowers or give loans to thesn in prefer-estee to uninsured borrowers, Over tune, therefore, H,, would beforced down relative to R

9. l’he competitive banking industrs’

assumption says simply that, in equilihrium, relative rates aresuch that any imsdividual hank will he indifibrent to offering thenext loan to either an insured or an ssninsured horrosver.

scribes this new demand curve for total credit with theintroduction of the government guarantee program. AtR,~,there is now an excess demand for loans of theamount L2 L0. This puts pressure on 11, to rise.Furthermore, as banks issue more loans, they will sellgovernment securities. Therefore, the rate of intereston these securities, 11

g’ increases. The increase in Hg

causes the credit supply curve to shift up, so that lesscredit will be supplied at any given 11,. Finally, asindividuals take out additional loans, they increasetheir demand for titles to capital goods, causing therateof return on these assets, 11

k’ to fall. This reduces,in part, the demand for loans, but does not shift thedemand schedule hack to D0.’3

The new portfolio equilibrium will be at some newloan rate, H,,, greater than 1190, and will be character-ized by a higher K, and lower 11k~Furthermore, if thecredit market is stable, the equilibrium rate of

interest on guaranteed loans, H, —5, will be less than

~it is also the case that, from general portfolio considerations, the

demand for credit will shift out as R, rises. For mtotational conveni-ence, these demand curve shifts have heemi suppressed in figure 2.

11r1

L3 L~ L0L4 Credit

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H,~.~ At this new set of interest rates, there will be atotal supply ofcredit of the amount L4, consisting of L3non-guaranteed loans and L4 — L3 government-guaranteed loans. Loans to borrowers ineligible forgovernment-guaranteed loans of the amount L3 —

that would have been made at H,~are no longer made.

The portfolio readjustment described above repre-sents the initial response to the introduction of thegovernment guarantee program. Because relativeyields on financial instruments have been altered, thestocks that households wish to hold will change. This,in turn, will alter the allocation of flows over time. Inparticular, because the demand price for capital hasincreased (11k has fallen), there is an increase in thedemand for real capital, stimulating the production ofthese goods and increasing aggregate demand ingeneral.’5

The increase inaggregate demand can take the formof an increase in prices or real income. Suppose thatreal income begins to increase first, transiently risingabove full-employment output. This increase gener-ates increased savings to provide the real resources toaccommodate the real investment.

Figure 3

The Loan Market, Including Government Direct Loans


Re

Overtime, however, the demands on real resourcesbegin to be reflected in increased prices. These in-creases reduce real cash balances and real holdings ofgovernment securities by more than they otherwisewould have been. In an attempt to maintain the realholdings of these assets, banks would decrease theirsupplies of credit, forcing loan rates up. The long-runequilibrium would then be characterized by a declineto full-employment real income, a higher price leveland lower real supplies of monetary base and govern-ment interest-bearing debt. The distribution of loans

hero see this, note that the initial shock was an increase in loans

supplied at anygivenR9. IfR

9, — Sr’R90, then demand by insured

borrowers is less than L0 — L,, and demand by uninsured borrow’ers is L3<L,, Thus, if R~5— S~R

10,an increase in the planned

supply of loans causes a decrease in equilibrium loans supplied,implying an unstable equilibrium. For the purposes of this paper,we shall rule out unstable equilibria. See Mary Kay Plantes andDavid Small, “Macroeconosnic Consequences of Federal CreditActivity,” in Conferences on the Economics of Federal CreditActivity, Pan 11—Papers (Congressional Budget Office, 1981) andcomments on it by Ceorge von Furstenberg, in Conference on theEconomics of Federal Credit Activity, Pan 1—Proceedings for amnore complex model that permits themmm.

miover time, the subsidy on the government-guaranteed loans mustalso he paid. It is assumed here that lump-susn taxes are raised topay for them, so that the subsidy itself represents a transfer fromthe population at large to recipients of governsnent-guaranteedloans and, as such, does not represent a change in aggregatedemand.

would be such that recipients of government-guaranteed loans would have a greater command overresources at the expense of borrowers ineligible forguarantees and the population at largewho pays for thesubsidies in the program.

introducing a Government DirectLoan P.rogram

Now consider the consequences if the governmentinitiates a direct loan program instead of a loan guaran-tee program. To facilitate the comparison, suppose thegovernment again provides the same subsidy rate perdollar of loan, 5, so that the interest rate on govern-ment direct loans, H,,~,is

(2) R,,~= .H~ — S.

Further, suppose the same individuals are eligible forthe govermnent direct loans as were eligible for theloan guarantees. As figure 3 shows, under theseassumptions, D0, D, and D2 are the same as in figure 2except that the horizontal distance between D, and D2now describes the demand for government direct loansinstead of guaranteed loans. H,~and L0 describe thebank loan rate and volume of credit before the intro-duction of the direct loan program.

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FEDERAL RESERVE BANKOF ST. LOUIS DECEMBER 1983

To examine the forces at work when the direct loanprogram is introduced, consider the demand and sup-plyof credit at H,0. First, there will be an excess supplyof loans that the banks wish to issue of the amount

— L,. This is because those customers who hadtaken out bank loans before, now find that their eligi-bility for direct government loans reduces their cost ofcredit. Consequently, they no longer demand hankloans at H,~.At 1190, however, banks would not want toalter their planned supply of credit; the decreaseddemand and unchanged supply mean an excess supply.Second, at 11~o~the total demand for credit has in-creased to L2 from L0. To finance this demand forgovernment direct loans, the government will issuegovernment securities. Thus, there is also an excesssupply of government securities. This causes H,to rise,shifting up the credit supply function of banks to, say,

While ~2 is drawn such that 119 rises in the newportfolio equilibrium, this need not he the case. At

an increase in K4 increases the opportunity cost ofbank loans. This may or may not offset the cost de-creases that accompany the reduction of the scale ofbank loan operations to L, from L0: if it does offsetthese cost decreases, then 119 will rise; if it does not, H,will fall.

The impact on aggregate desnand is qualitatively thesame as occurs with an increase in guaranteed loans.There is an increase in the demand price of capital (adecrease in 11k), making it more profitable for firms toinvest. This puts pressure on output and prices toincrease. The increase in price, in turn, reduces realwealth, causing output to fall to its full-employmentlevel. This causes loan rates to rise and the demandprice of capital to fall. The real quantity of monetarybase will be less than it was at the initial equilibrium.

A Gompensated Ghanze inGovernment-Guaranteed and Direct Loans

Columns 1 and 2 of table 3 describe the portfolioeffects of both the gimaranteed loan and direct loanprograms. With the exception of the loan rate on unin-sured bank loans, these results are identical. The ques-tion now to he addressed is: What are the conse-quences on interest rates and aggregate demand if thedirect loan program is expanded and the guaranteeprogram reduced, so that there is no change in the totalntimber of individuals eligible for the governsnent sub-sidized rate of interest? In other words, does it matterwhether a direct loan program is used instead ofa loan

Table aThe Portfolio> Effects of Changes inGovernment Credit Programs onInterest Rates and Aggregate Demand

ProgramChange

Increase inIncrease itt Increase in direct bansgqvemrnent go~-emment anddecrease

Effect on guarantees direct loans in guarantees

tncI’aas~ uncertain decreaseincrease incre e rmcrease

fl~ decrease decrease decreaseAggregatedemand increase increase increase

guarantee program with the same borrowing rate andthe same eligibility requirements, and, if so, how?’6

To answer this question, suppose the governmentcurrently has both programs in operation. Further,suppose that the interest rate on direct governmentloans is equal to the net of subsidy rate, H, —5, ongovernment-guaranteed loans. Thus,

(3) H, = Hg, + S = Rd + S

This ensures that potential recipients of either govern-ment program receive the same subsidized rate. Theanalysis can be followed in figure 4, where Dc de-scribes the demand function for non-insured bankloans, D~is the demand for total bank loans (govern-

~Fheresults to this point cami he explained intssitively by mnaking aim

analogy tn government programs in the field of mnedical care. Ifmore individuals become insured under, say, the Medicare pro—grani, the total demand br hospital care will imicrease. If hemie’flciaries of the programn mnay use any private hospital, the cost ofhospital care at these institutions will rise, crowdimig out someunimssurcd individuals, though not as mnany as the incm’eased num-ber of insssred patients (or costs svould not Isave increased). II. onthe other hand, insured patients can receive ssshsidized care omilyif they go to certain specified government hospitals, as requiredsay, by theVeterans Administration programs, demand at minn—\’Ahospitals ‘vill fall, causing hospital costs there either to decrease(because ofthe lower utili-zation) or increase (because the rlemnamsdfor doctors will have increased causing their salaries to rise at allhospitals). The Medicare program is simnilar to the loan gmmaranteeprogramn. TheVA program is analogous to the dim’ect loan prngrasnCosts to the patients are analogous to the loan rates to borm’owerswishing to pmsrchase capital and the price of doctors’ sem’vices is ananah g to the interest rate ob govermmment securities. The qsiestionnow addressed in the text substituting direct loans for guaran-teed loans in the health care analogy is the following: What isthe effect on tlse cost ofmedical care if veterans’ wives over age 65‘vere added to the VA programn and ssot permitted to use theMedicare programn

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fSgure 4

The Loan Market, ii Direct Loans Replace Guaranteed Loans

Louir roteof interest

ment-guaranteed and non-guaranteed), and D is thetotal demand for credit nnder the pricing assnmptionmade above. The initial equilibrium is at H0, with Lnon-guaranteed loans, L — L government-guaran-teed loans, and L — L; direct government loans.

Now suppose that the government changes its poli-cies so that some individuals lose their eligibility forgovernment-guaranteed loans, but are now eligible forgovernment direct loans. This is described in figure 4by a shift in the demand for total bank credit from Dto Dc. Suppose initially that the loan rate remained atH;

0and Hg remained at its initial level. There would

then be an excess supply of total bank loans of theamount L—L4 and, because government directloans are financed by issuing government securities, anexcess supply of government secnrities of an eqnalamount.

The former puts pressure on H, to fall and the lattercauses government security rates to rise until a newportfolio equilibrium is established. If the system isstable, then H; will fall, say, to R,, and Hg will riseabove its initial rate.1’ Because the total supply of

“An implication of this analysis is that an increase in the federal

budget need not, ceteris paribus, cause loan rates to rise norcrowdout borrowing and investment by the private sector. This is

credit has increased, there will be an increase in thedemand price for capital and in the level of aggregatedemand18 Therefore, the analysis suggests that theuse of government direct loans increases aggregatedemand more than government guaranteed loans thatprovided credit to the same individuals at the samerate of interest.

As a consequence of the increase in aggregate de-mand, either quantities or prices must rise to equili-brate the goods market. If prices rise, interest rates onloans and on titles to capital tend to rise as demands forthese instruments decline with the decrease in realwealth. Because both investors and consumers facedecreases in wealth from the price rise, these groupswill reduce their (real) planned expenditures. It fur-ther seems reasonable to suppose that personal con-sumption will decrease, so that borrowers obtain anincreased command over the flow of real resources.Thus, even with the price adjustment, the demandprice ofcapital is greater than it was before the changein the program.

S I] vIMABY

This article has argued that government direct loanprograms are more stimulative than governmentguarantee programs with identical amounts of creditassistance. 19 The use of the direct loan program will

because direct loans by on-budget agencies are included in thebudget deficit. Such direct loans could increase through a com-pensated decrease in government-guaranteed loans, in which easethe analysis implies that private loan rates would fall. Even assuneompensated increase in direct loans by on-budget agenciesmay cause an initial decrease in loan rates (see Fried, GovernnwntDirect Loans).

‘51n figure 4, the fall in It~will, for a given 5, lower R.~and H andtherefore increase the demand for direct and guaranteed loans.This explains only part of the increased demand. The same qual-itative results also hold when the total subsidy (L — L~)S,re-mains fixed. (The ease of the fixed total subsidy is derived in Fried,Government Direct Loans.) The rise in E~causes individuals andbanks to conserve (Sn their cash balances and excess reserves. Thispermits a total expansion of credit as the yield on deposits isincreased, increasing total bank deposits. The sufficient condi-tions for a compensated increase in government direct loans to beexpansionary are that the demand for capital goods be more re-sponsive toloan rates than to government security yields, and thatthe demand for the monetary base and deposits be more respon-sive to government security rates than to loan rates.

‘9Critical to this result are the assumptions that government securi-ties and guaranteed loans are not perfect substitutes for oneanother in bank portfolios, that guaranteed loans are closersubsti-tutes to non-guaranteed loans than are government securities,that the demand for capital is more responsive to loan rates than togovernment security rates and that demand for the monetary baseresponds more to government security rates than to loan rates.

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generate lower loan rates to borrowers not receivinggovernment assistance, higher interest rates on gov-ernment securities and a higher demand price forcapital.

These results can be seen intuitively by supposingthat, in increasing direct loans, the government arbi-trarily exchanges $1 million of government securitiesfor $1 million of previously issued, government-guaranteed loans in bank portfolios. Banks then findthemselves with an excess supply of government secu-rities and too few loans in their portfolios, which putspressure on government security rates to rise and loan

rates to uninsured borrowers to fall. The lower loanrates provide an incentive to households to purchasemore capital and other commodities with borrowedfunds so that either aggregate demand or the demandprice of capital increases, or both.

Additional implications are that government budgetdeficits as currently measured may not accuratelyreflect the government’s impact on the credit marketand private capital expenditures; also, because govern-ment credit programs can change relative interestrates, any specific interest rate may be misleading as anindicator of financial market conditions.

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Government Loan and Guarantee Programs - St. Louis Fed