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An increase in Government Purchases of Goods and Services will cause an increase in the cost...

An increase in Government Purchases of Goods and Services will cause an increase in the cost of borrowing which will cause a decrease in Investment. True or false and why?

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Answer #1

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An increase in governement purchases of goods and services means increase in government spending in the goods market. This will shift the downward sloping IS curve rightward as IS curve represents equilibrium in goods market. Rightward shift of IS curve implies that interest rate increases in the market. Interest rate is the cost of borrowing so as interest rate increases it means cost of borrowing also increases. As cost of borrwing increases, investment will decline. This is because as interest rate increases, return on funds increases so savings will increase and investment will decline. Thus, cost of borrowing and investment are inversely related. So, increase in Government Purchases of Goods and Services will cause an increase in the cost of borrowing which will cause a decrease in Investment.

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