Question

A) Based on IS-LM-bb model, explain the impact of the following on the market and justify the shift in bb curve when there is a/an:

i. Increase in budget deficit

ii.decrease in money supply

B) There are two (2) ways that authorities may try to finance increased government expenditure (G), Explain

a. By printing extra money and using the money directly to finance its expenditure

b. By borrowing — that is by selling bonds to economic agents

Answer 1

A) i) Increae in budget deficit means goernment will to try to sell more bonds to finance spending. Bond supply will increase, with respect to given demand. So, bb curve shifts

ii) Decrease in money supply can increase the opportunity cost of money. So, people will shift from money to bonds. So demand of bonds increase and there is a shift in bb curve.

B) Governments finance deficit by printing extra money. This is called seignorage. They print enough money so as to cover up the deficit. However, the strategy does not work if inflation is unstable. In that case, printing money never suffices and can cause hyperinflation.

Government can also cover deficit by selling government bonds. Here, government borrows from the market. So, it has to compete with private players as well. Usually, people who are very risk averse goes to invest n government bonds as such bonds are safer. Hence, funds fall for private investors and so, interest rates rise. This is called crowding out.