Final answer:
An increase in government deficit leads to a rightward shift in the demand for financial capital, resulting in higher equilibrium interest rates and potential 'crowding out' of private investment.
Step-by-step explanation:
Changes in the amount of government deficit/surplus have significant implications for the equilibrium interest rate in the economy. If the government increases its borrowing, the demand for financial capital shifts to the right, from Do to D1, as indicated in various figures like 18.8 and 31.8.
This shift indicates that the government is competing with private sectors for financial capital, which leads to a rise in the interest rates.
In an initial equilibrium without the deficit, the interest rate might be at 5% with an equilibrium quantity of financial capital being 20% of GDP. However, when the government's borrowing increases due to a budget deficit, this creates a new demand curve for financial capital.
As the government enters the market to borrow funds, it competes with private borrowers, effectively reducing the supply of capital available for private investment – a scenario often described as crowding out.
Consequently, in the new equilibrium (E1), the interest rate is higher, say at 6%, and the quantity of financial capital in terms of GDP might increase to 21%. The rise in the interest rate deters some investors whose projects might not be profitable at the higher rate, thus potentially reducing private investment.
This dynamic illustrates how government deficit spending can affect financial markets and overall economic activities through changes in interest rates.