Question

Suppose that the federal government begins to run a large budget deficit at a time when many productive resources are idle factories are operating far below capacity in most industries, and there are surplus of labour in almost every area of the economy.

1. How might the existence of all these idle resources prevent even a very large increase in government borrowing from leading to an increase in interest rates?
2. If you found part (a) hard to answer, ask yourself whether an expansionary monetary policy would be likely to cause inflation under the circumstances described. Remember that it is primarily expectations of more rapid inflation that cause interest rates to rise when monetary policy becomes highly expansionary.

Answer 1

Answer:Federal budget deficits are an excess of federal spending over revenue.They are generally financed by borrowing:Bonds are issued to cover the deficit,and these bonds are bought by household or firm in the US private sector.

Deficits Stimulate Agrregate Demand

An increase in federal budget deficit from one period to the next stimulates aggregate demand in the economy.The spending done by the federal government either stimulates demand directly(say,when the money is spent to build a road) or indirectly by transfering resources to households who can then undetake more consumption spending(say,by sending out Social Security checks).If federal spending rises faster than taxes and deficits increase,economywide aggregate demand gets a boost.Higher demand in turn induces firms throughout to economy to hire more people and this leads in turn to lower unemployment.As more prople receive transfers from federal government,this leads to greater demand for concrete,steel,capital equipment,restaurent meals,and so on.This in turn leads to increased demand for workers these goods and services.

Risks of Expansionary Monetary Policy  

Expansionary policy is a popular tool for managing low-growth period in the business cycle,but it also come with risks.Expanding too much can cause side effects such as high inflation or an overheated economy.There is also a time lag between when a policy move is made and when it works its way through the economy.

This makes up-to-the minute analysis nearly impossible,even for the most seasoned economist.Effect of high ininflation includes an increase in the opportunity cost of holding money,uncertainity over future inflation which may discourage investment and savings.

As people and businesses spend more quickly in an effort to reduce the time they hold their depriciating currency,the economy itself awful in cash that no one particularly wants.In other words,the supply of money outstrips the demand,and the price of money-the purchasing power of currency-falls at an even faster rate.