Final answer:
A reduction in interest rates by a central bank typically lowers borrowing costs, spurring business investment and consumer spending, which in turn can lead to increased GDP and employment. However, high government borrowing can counteract these effects by raising interest rates and crowding out private investment, potentially hindering GDP growth.
Step-by-step explanation:
When a central bank implements a reduction in interest rates, it aims to make credit more accessible, thereby stimulating economic growth. Lower interest rates reduce the cost of borrowing for businesses and households. This encourages business investment in physical and human capital and consumer spending on big-ticket items like homes and cars. As these spending activities increase, the Gross Domestic Product (GDP), which is a measure of the aggregate economic output, typically grows. Additionally, employment is likely to expand as companies boost production to meet the higher demand.
However, the relationship between interest rates and GDP can become complex if government borrowing is substantial. Large deficits can lead to higher demand for financial capital, potentially pushing interest rates up, despite the central bank's efforts to keep them low. This can crowd out private investment due to increased competition for financial resources, possibly stunting GDP growth in the long term. If a government resorts to inflationary policies to manage high debt levels, it could undermine real wealth and economic confidence, having adverse effects on GDP.
Nevertheless, in the normal course of economic policy, lower interest rates set by a central bank are generally expected to lower the cost of borrowing, increase investment and consumption, and subsequently boost GDP and employment as a result.