When the Government runs a budget deficit, it must sell Treasury bonds to finance that deficit....

When the Government runs a budget deficit, it must sell Treasury bonds to finance that

deficit. To analyze the impact of increased government spending, assume the Treasury will

be selling new 1-year Treasury bills. Use a supply and demand for bonds model to

determine what is likely to happen to interest rates on 1-year bills. (Explain your graph)

Expert Solution

Budget deficit is a situation when the budgeted expenses are more than the budgeted revenues. Governments across the world often face budget deficit and they follow various measures to raise funds to cover the expenses. One such measure is public borrowing where government raises funds from the public internally in the country. It can raise funds through issue of bonds. Since governments have a good credibility against default, they also don't face the case of paying exorbitant interests on their borrowings.

Here, assume that the treasury will be selling new 1 year Treasury billls. Below figure will assist in understanding the impact.

Here loanable funds is the amount of funds demanded and supplied as loan for a particular rate of interest. When the government sells treasury bills, the demand for loanable funds in the market increases. This will move the demand curve to the right from D0 to D1. The supply curve will be unaffected as loanable funds for the particular rate of interest is at optimum. Any increase in supply needs a raise in the rate of interest. Hence the increase in demand for loanable funds will push the interest rate from r0 to r1. Thus the market rate of interest will increase.

Such a move will cause a crowding out effect in the market where private borrowers will find it difficult to borrow at higher interest rates.

Rahul Sunny answered 1 year ago

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