Question

How does a government deficit affect the interest rate, the quantity of loanable fund, and economic growth? Explain your reasoning in detail with appropriate diagram(s).

 

Answer 1

 

The budget deficit arises when expenses exceed revenue and it impacts the financial health of a nation. When the government faces a budget deficit it decreases the amount of saving in the country; and consequently supply of loanable funds curve would be shifting towards the left, and rates of interest will increase in an economy. Higher rates of interest can decreases the investment (i.e. crowding out effect).

A budget deficit impacts the supply and demand. A deficit raises the demand for loanable fund because government need to borrow money thus there will be an increase in the demand for loanable funds. Deficits reduce the supply of loanable funds. The reason is that the national savings includes both the public savings (T-G); and it is the source of the supply of loanable funds. When there is deficit, T-G becomes smaller and will shift the supply of loanable funds

Thus, increase in budget deficit leads to a reduction in investment. When government borrows for financing the deficit, it causes fall in investment as there are less funds available for investment. It is termed as crowding out. For long-run economic growth investment is a vital factor. Thus, a budget deficit decreases the growth rate and future standard of living in an economy.

In the enclosed graph, when government runs a budget deficit the supply of loanable funds is decreased thus it shift towards left from S1 to S2. It increases the equilibrium interest rate from i1 to i2. It decreases the equilibrium quantity of loanable funds and investment from L1 to L2.