Question

1) Suppose that this year the government borrows €10,000 million more in the bond market than last year.

a) What happens to the interest rate? Explain in which direction it would go. No need to make calculations.
b) What happens to the level of investment? Explain in which direction it would go. No need to make calculations.

2) Using the data below, calculate for each year: the GDP deflator, the inflation rate, and real economic growth:
2016 2017 2018
Nominal GDP 4,540,332 5,987,201 7,231,600
Real GDP 3,723,072 4,670,017 6,436,124

Answer 1

1)

a) Government borrows will decrease the system's liquidity because the system is acquiring bonds by spending money, and consequently system will be left with less money; and due to which there arises the crowding out effect. The money borrowing from the bond market crowds out money meant for the investment by the company. As a result there will be a hike in the interest rate for providing incentive to households for depositing their money in the bank and a higher cost for the companies. Thus due to the crowding out effect there will be a fall in the loanable funds

b) When the government borrows money from the bond market, the rate of interest increases and as a result the investments will reduce (i.e. shift to left) because companies will be less willing to pay high interest rate, while savings will increase. The higher interest rates will reduce investment. The borrowing results to the crowding out effect; and thus indicates that private sector will have less money to spend and invest. Thus investment will decrease and savings will increase.