2. Whether government budget deficits are related to interest rates is a basic issue of
macroeconomics. Under what conditions would the two variables be related? Under what
conditions would the two variables not be related? Does the relationship between deficits and
interest rates have a particular name in macroeconomics? Illustrate your answer with appropriate
diagram(s). (20 points)
Solution
Deficit arise when government expenditure exceeds its revenue. Deficits can be financed by
monetary growth. However, if that is not the case then, the governments creates incentive for
private sector to buy more government bonds. Issuing of more bonds, leads to a fall in the
interest rates.
The increase in the interest rate reduces the quantity of private investment demanded (crowding
out private investment).
Higher interest rates also can reduce the private sector\'s demand for capital, thereby reducing the
demand for commercial and retail borrowing..
2. Whether government budget deficits are related to interest rates i.pdf
1. 2. Whether government budget deficits are related to interest rates is a basic issue of
macroeconomics. Under what conditions would the two variables be related? Under what
conditions would the two variables not be related? Does the relationship between deficits and
interest rates have a particular name in macroeconomics? Illustrate your answer with appropriate
diagram(s). (20 points)
Solution
Deficit arise when government expenditure exceeds its revenue. Deficits can be financed by
monetary growth. However, if that is not the case then, the governments creates incentive for
private sector to buy more government bonds. Issuing of more bonds, leads to a fall in the
interest rates.
The increase in the interest rate reduces the quantity of private investment demanded (crowding
out private investment).
Higher interest rates also can reduce the private sector's demand for capital, thereby reducing the
demand for commercial and retail borrowing.
