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QUESTION 8 An increase in government spending that is NOT financed by an increase in taxes...

QUESTION 8

  1. An increase in government spending that is NOT financed by an increase in taxes will cause which of the following?

    an increase in interest rates and an increase in planned investment

    a reduction in interest rates and an increase in planned investment

    a reduction in interest rates and a reduction in planned investment

    an increase in interest rates and a reduction in planned investment
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Answer #1

An increase in government spending that is not financed by an increase in taxes, is actually financed through borrowing by the government.

Now, when the Government borrows to finance its spending, the demand for loanable funds Increase in the loanable funds market. At the existing rates of interest , there is now excess demand for loanable funds which leads to an increase in the interest rates. Now, Increase in the interest rates leads to a reduction in the planned investment due to negative relationship between Interest rates and planned Investment.

Hence, an increase in government spending that is not financed by an increase in taxes will cause an increase in the interest rates and A reduction in the planned investment.

Therefore, Fourth Option is correct.

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