Final answer:
Government budget deficits can increase interest rates by increasing the demand for financial capital, but during recessions, this may not happen if government spending substitutes for a lack of private investment. A graph showing a shift in the demand curve from D0 to D1 would typically illustrate this effect on interest rates, but it must consider the context of the economic cycle.
Step-by-step explanation:
Government budget deficits can impact interest rates due to changes in the demand and supply for financial capital. Traditional economic theory posits that increased government borrowing will lead to higher interest rates, as the government demands more financial capital, shifting the demand curve (D0) to the right (D1) in the bond market. This is illustrated in an example where a shift of the demand curve from D0 to D1 results in a new equilibrium (E1) with a higher interest rate of 6% compared to the original 5% rate at equilibrium (E) with no change in supply (S0).
However, during a recession with deficit spending, some economists argue that such an increase in interest rates may not occur. They reason that when private investment is scarce, government spending can help maintain the demand for financial capital. Consequently, this government investment might offset the negative effects of deficit spending on interest rates, keeping them more stable than they would otherwise be, despite the increase in government borrowing.