Final answer:
The interest rate effect leads to higher interest rates as prices rise, which decreases borrowing by businesses and households, reducing overall economic activity. Large-scale government borrowing can shift the demand curve for financial capital, resulting in a new equilibrium with even higher interest rates.
Step-by-step explanation:
The interest rate effect can be understood as a phenomenon in which increasing prices for goods and services lead to a higher demand for money and credit as businesses and consumers require more capital to make the same purchases. This demand for credit in turn pushes interest rates higher. Consequently, the rise in interest rates typically dampens borrowing behavior, causing both businesses and households to cut back on investment and consumption. For businesses, this means less borrowing for expanding operations or making large capital investments. For households, a higher interest rate translates to costlier loans for buying homes or vehicles, which can lead to reduced spending in these areas. With a decrease in consumption and investment, the overall economic activity can slow down.
In the context of government borrowing, if a government borrows substantial amounts of money, it can result in a shift of the financial capital demand curve. This shift leads to new equilibrium points in financial markets characterized by higher interest rates and possibly a change in the equilibrium quantity. For example, an increase in government budget deficit can cause the demand curve for financial capital to shift from D0 to D1, leading to a new equilibrium with a higher interest rate—say, from 5% to 6%—and a changed equilibrium quantity of financial capital relative to GDP.