Question

Of the following true statements, which statement might be a reason that budget deficits make interest rates go up?

• The increased demand for loanable funds in the private market will drive interest rates up.

• Tax revenue collected to make interest payments on the debt is given to Americans who can then use it to make purchases.

• They represent the difference between tax revenue and government expenditures.

• Large budget deficits reduce the strength of the domestic currency.

Answer 1

Budget deficit is the excess of the government expenditure over the revenue. In most of the countries it is found that the government spends more than what it collects from the taxes and hence has to borrow money from different sources to finance this expenditure. The government can borrow money from private sector or any other national or international organisation and hence has to pay a rate of interest on the money borrowed.

Since the government may also borrow from the private sector, so this increases the demand for loanable funds in the capital market, but the supply of loanable funds in the market is limited and hence the increase in demand of loanable funds increases the interest rate. So the interest rates increase as a result of increase in the demand for loanable funds.

So first statement is the correct reason.