Question

Suppose that in the next federal budget, the government decides to eliminate all (government) purchases that are financed by borrowing because the politicians worry about a budget deficit. What is wrong with this argument? Briefly discuss using the loanable fund market (no bullet points please). (2.5 marks)

Answer 1

Elimination all government purchases will firstly reduce aggregate demand in the economy . Secondly it has been mentioned that the government will reduce borrowing or eliminate budget deficit . So reduction in borrowing will create less demand in the loanablefunds market . So the equilibrium real interest rate will rise . This will set off investors from investion since interest rate is the cost of investing . So reduction in investment will cause decline in national output and GDP and growth will be hampered . So ultimately again to push the economy upwards the gvernment will have to increase spending .