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A fiscal stimulus--for example, both an increase in G and a decline in T--will leave the...

  1. A fiscal stimulus--for example, both an increase in G and a decline in T--will leave the government budget deficit higher for a sustained period. What is the effect of such a policy on the long run equilibrium interest rate? Is this a policy that you should expect would raise potential output? Explain.

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Answer #1

When there is a persistent and high government budget deficit for a sustained period, and the fact that government uses borrowing to finance it, it can result in crowding out the private investment which is essential for capital accumulation. The rate of interest is therefore increased from its equilibrium level. This policy is not likely to increase the potential output because it reduces the capital accumulation and thereby result in reducing the productivity of the nation in the long run. This is also one of the reason why persistent budget deficits are considered dangerous for the wealth of the economy.

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