Final answer:
An increase in budget deficits by 1% of GDP is expected to cause a rise in long-term interest rates of between 0.5-1.0%. This phenomenon occurs because government borrowing increases the demand for credit, potentially leading to crowding out of private investment as higher interest rates make it more costly for businesses to invest.
Step-by-step explanation:
A consensus estimate based on a number of studies suggests that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will most likely cause an increase of 0.5-1.0% in the long-term interest rate.
Governments borrow funds to cover budget deficits, and this borrowing can lead to higher demand for credit. The increased demand typically raises interest rates, as lenders require a higher return on their loans.
Higher interest rates, in turn, can make borrowing more expensive for businesses and individuals, potentially slowing economic investment and growth.
Crowding out is one effect of government borrowing that can occur, where government deficits lead to higher interest rates, which then discourage private investment in physical capital.
It is important to note that there are studies with varying conclusions regarding the strength of this relationship. While some studies show a direct and significant impact of budget deficits on interest rates, others suggest the connection is more limited, especially in certain economies such as the United States.
Nevertheless, as deficits grow, the concern over rising interest rates increases.