The Effect of Budget Deficits upon Interest Rates

Question 1

The effect of budget deficits upon interest rates

A budget deficit occurs when the tax receipts is less than the spending, hence the likelihood of a stimulating effects occurring in the short run is high. Sales of Bills, Notes, and Treasury Bonds are some of the mechanisms that the government uses to finance (cover) the deficit. However, in most instances, the government will prefer to take loanable funds to finance the deficit, thus, the demand of the loanable finance will increase. As demonstrated above, the demand curve will shift to the right (D1 to D2) which will also attract higher interest rates (r1 to r2). A government that has a budget deficit is often likely to experience an economic phenomenon known as crowding out. Nevertheless, the demand of funds in mortgage borrowing, consumer, and private sector might reduce in an event where there is budget deficit according to economy theory. Ultimately, interest rate increases as a result of budget deficits, and this condition limits various groups of private borrowing despite the existence of other offsetting factors.

Question 2

Effect of strong economic growth upon interest rate

Strong economic growth in a country is characterized by increased investment. Therefore, the demand for loanable funds will increase, which will rise the interest rate. Thus, interest rate rise during expansion and falls during recession.