Question

The purpose of this assignment is to practice economic theories related to saving, investment, and the financial system

Are Future Budget Deficits a Threat to the​ Economy?

Congress gives the Congressional Budget Office​ (CBO) the responsibility of estimating the effects of federal spending and taxing policies on the economy. An Associated Press news story on a CBO report noted that federal budget deficits in the United States were likely to increase in future years. According to the​ CBO, these higher deficits might​ "pose a threat to the economy by crowding out business investment and threatening a spike in interest​ rates."

​(Source: Andrew​ Taylor, "CBO: Deficits to Drift Lower on Lower Health​ Costs," Associated​ Press, April​ 14, 2014.)

a. What did the CBO mean by a​ "spike in interest​ rates"? Why might increased federal budget deficits lead to a spike in interest​ rates? Illustrate your answer with a graph.

b. Is the spike in interest rates connected to crowding

​out? Why might crowding out be considered a threat to the​ economy?

Answer 1

a. What did the CBO mean by a​ "spike in interest​ rates"? Why might increased federal budget deficits lead to a spike in interest​ rates? Illustrate your answer with a graph.

Budget deficit means that government spendings are more than government earnings.

Balanced budget shows financial prudence by government and also shows financial discipline. This helps to get more credit rating for a country by international agencies. This attracts good investments in both forms direct investments and portfolio investments. It makes country to switch from primary to secondary and then to tertiary sectors which helps people to have better standard of livings.

When budget deficit is higher then in order to keep accounts intact it has to borrow money and as government needs more money, demand for money goes up and as demand goes up, interest rates also go up. Refer fig below:

As Demand for money shifts from D1 to D2, interest rates go up.

It becomes expensive for businesses to borrow and hence investments are less in any economy, repayments are also affected negatively.

b. Now, look at both diagrams a and b together, as interest rates are going up from i1 to i2, investment levels fall from I1 to I2. This shows that more government borrowings will lead to less private investments due to rising interest rates and this is what crowding ot effect is. Crowding out drives efficient and effective private investments. It leads to more job loss and also increases interest burden on government. Government will be stuck in debt cycle and infrastructure is not developed properly, standard of living remains low in any country.

b. Is the spike in interest rates connected to crowding ​out? Why might crowding out be considered a threat to the​ economy?