Question

a)Explain the impacts of an increase in the budget deficit and increase in money supply on goods, money and bond markets equilibrium

b)Using 1S-LM-bb figure, explain why the bond market curve (bb curve) is positively sloped and relatively flat.

Answer 1

The impact of budget deficit leads to change in public sector debt, high level of interest payments, change in aggregate demand, investment in public sector, higher tax rates in future and lowering level of consumption, change in inflation level etc. The increase in budget deficit will increase the public debt. The government tried to borrow more from the private sector. This high rate of government borrowings will increase the rate of interest and this will attract more investors to the market. In common perspective, budget deficit is the lowering tax rates and increased government spending. This high level of government spending will raise the aggregate demand and overall production. The spending of government mainly used for infrastructure development which used for long term production capacity. This will improve the level of growth. At current situation this budget deficit is good for the economy, but in future it will leads to increasing rate of tax rate sand cut in government expenditure. The increased government borrowing will crowd out the private investment and also reduce the size of private sector.
In IS LM framework the bb curve is horizontal to the X axis. This bb curve shows the balance of payment in the economy. Every economy tried to maintain their balance of payment. It is flat because of the inelastic nature towards the interest rate. The interest rate for the balance of payment remains same for different levels of output. On the other hand, it is positively sloped shows the positive relation between interest rate, exchange rate and the level of output.