Question

What effect would government deficit spending have on interest rates? Explain. This change in interest rates caused by the government deficit spending would have a long run effect on investment spending. What effect would that be and why?

Answer 1

Government deficit spending will increase the government expenditure component of the aggregate demand and output. This will lead to the shift of the IS curve to the right and this will increase the output and the interest rates as shown in figure. In the long run this increase in interest rate will restrict private borrowing and investment by private sector. This effect is known as the Crowding out effect of government deficit spending. This reduction in private investment happens because the government investment has caused rise in interest rates and at the higher interest rate, borrowing becomes costly and private investment unviable. This may have a negative effect on the economic growth of the country in the long run.