Question

A country reduces its government budget deficit and also makes political reforms that lead people to believe this country’s assets are less risky. Given the combination of a reduced deficit and lower asset risk, what happens to the interest rate?

Answer 1

The higher government budget deficit increases shifts the saving curve leftward which lowers the supply of loanable funds but with the reduction in the government deficit, the supply of lonable funds will not change much. Also, with the reforms in the political sector, the investment will increase in the market and will cause downward sloping investment curve to shift upward.

Therefore, with the rise in investment and constant saving, the interest rate will rise in the market.