Question

In view of the large adverse impact of COVID-19 on the world economy, many governments have implemented expansionary fiscal policy. Together with a decrease in tax revenues, the governments have suffered large deficits. How does a government deficit affect the interest rate, the quantity of loanable funds and economic growth? Explain your answers with a diagram.

Answer 1

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Question:

Answer:

Fiscal Deficit ; Its a cause of gap between government revenue and income. When government income increase more than revenue then fiscal deficit occur. During the crisis or recession the government adopts a expansionary fiscal policy and increase spending with decreasing taxes. The main reason of recession is decreasing AD and when AD decrease its decrease output and price level. Decreasing price level and future uncertainty decrease production level and decreasing production level increase unemployment and decrease income level. Decreasing income level decrease AD that decrease output and price level and the economy fall down sharply and get enter into recession. During the COVID-19 the economy has shrunk rapidly and the world economy is facing a recession so, to boost the economic growth through increasing AD, the government have adopt expansionary fiscal policy. When government spending increase then its increase fiscal deficit. The gap between spending and revenue increase rapidly. So, full the gap or for funding the spending, the government borrow money through issuing securities. The government sell securities and raise money to full the fund requirement. When the government increase borrowing then its increase supply of securities in the market . The government securities are the safest securities and people invest in in bulk. During the recession when the there are huge risk in market the government securities give a better option for investment. Increasing borrowing increase demand for loanable fund and and increasing demand for loanable fund increase interest rate. Increasing government borrowing decrease or negatively affect to the private investment. Higher interest rate making borrowing costly for the private sector.  If the government borrows directly from the central bank or by printing money, there is an increase in money supply which may subsequently cause price inflation to rise. Other side increasing inflation depreciate domestic currency rate that makes foreign investors less willing to hold that countries debt. So, thes impacts negatively affect to the economy

You can see the increasing demand for loanable fund shift demand curve right from D to D and its increase interest rate from "r" to "r1". Quantity for loanable fund increase from "Q" to "Q1".

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