Question

In theory, an increased supply of government bonds -sold to raise funds when spending exceeds revenues-should increase government borrowing costs. Theory also says big deficits crowd out business borrowing and increase private borrowing costs too.

Do you agree or not and why?

Thank you.

Answer 1

Yes, in theory and practice, when the government expenditure exceeds the revenue, in other words a fiscal deficit, the government will resort to external borrowing to meet the expenditure needs. Increasing fiscal deficit would mean high supply of government bonds in the market decreasing the price and increasing the yields of the securities having similar maturities. This will increase the corresponding costs of government borrowing.

The increase in costs of borrowing would also mean a corresponding increase in costs of borrowing for private and business as the risk free rate is linked to the existing government borrowing rate. This would then increase the costs of borrowing across the market.