Question

In: Economics

Your essay must be written concisely and not exceed 700 words. Indicate your choice clearly Discuss...

Your essay must be written concisely and not exceed 700 words. Indicate your choice clearly

  1. Discuss the possible impact of budget deficits on interest rates and private investment in small island economies in the Pacific.

Solutions

Expert Solution

The budget deficit occurs when government expenditure is larger than the revenue of the government. The expenditure of the government is rising persistently but the revenue of the government is not sufficient to cover up the larger expenditure level.

Interest rate and budget deficit: When the government budget deficit rises, the government resorts to borrowing. The borrowing leads to the rise in the demand for money in the market. Thus the demand for funds shifts to right thereby leading to the rise in the interest rate. If central bank does not go for expansionary monetary policy, the interest rate will see the significant rise following the spike in the government budget deficit.

Furthermore, the investment by the private firm depends on the interest rate prevailing in the market. When the interest rate rises due to the government borrowing from the market, the private investment is discouraged, and thus investment level declines in the economy. Such a decline in the investment owing to the rise in the interest rate is also called the crowding-out effect in the economy.

it is argued by the supporters of deficit budgeting, the deficit of government budget must be funded through the printing of new money or government should not go for the market borrowing. if government goes for the printing of new money, the crowding-out effect would be zero here.

Thus, private investment will be discouraged only if the government goes for market borrowing only.


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