Question

Given an economy where government is deficit spending while operating at full employment.

1. Using a correctly labeled graph for real interest rates, explain how the increase in the deficit will affect real interest rates in the short run, ceteris paribus.
2. Explain the difference between government deficit and national debt by defining each concept.
3. Explain how private investment will be impacted by the government's deficit spending.
4. If the government continues deficit spending, show the impact on a correctly labeled short-run Phillips Curve. Label the initial position A and the new position B.

Answer 1

a. Using a correctly labeled graph for real interest rates, explain how the increase in the deficit will affect real interest rates in the short run, ceteris paribus.

The government is involved in deficit spending as put across by the question. This means that the government gets revenue which is less than its expenditure. The government has to bridge the gap between spending and revenue through borrowing because it is spending more. Due to the borrowing, a demand for loanable funds is created. Given the supply, the increase in real interest increases the demand for loanable funds. This is depicted in the below figure where deficit spending by government has increased the demand for loanable funds and has shifted the demand curve for loanable funds from D to D1 and has resulted in increase in real interest rate from r to r1.

b. Explain the difference between government deficit and national debt by defining each concept.

National debt means total outstanding borrowings of the government while Government deficit means excess of government expenditure over government revenue. The government deficit can give rise to further government borrowings hence results in increase in national debt.

c. Explain how private investment will be impacted by the government's deficit spending.

When government engages in deficit spending, it means that thegovernment is incurring an expenditure which is greater than its revenue. Since, government is spending more, it has to bridge this gap between spending and revenue. Government generally bridge this gap through borrowing. As government borrows to bridge the expenditure-revenue gap, it creates demand for loanable funds. This increases the demand for loanable funds in market for loanable funds. Given the supply, this increase in demand for loanable funds increases the real interest rate. This increase in real interest rate increases the cost of borrowing for private enterprises and forces them to restrict their borrowing. Since, firms used the borrowed funds to make business investment. This restriction in borrowing translates into reduced business or private investment. Therefore, the government's deficit spending results in decrease in private investment.

d. If the government continues deficit spending, show the impact on a correctly labeled short-run Phillips Curve. Label the initial position A and the new position B.

If the government continues deficit spending then aggregate demand in economy will increase which will, on one hand, will raise the price level and, on the other, will stimulate production and employment. Thus, this combination will result in fall in unemployment rate and rise in inflation rate and there will be upward movement along the short-run Philips curve. This is depicted in the figure below by way of movement from point A to point B on back of continued deficit spending by government.

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