Question

The government is currently operating at a balanced budget. Unemployment begins to rise, so the government increases government purchases. Because of this action, the government will now be deficit spending. (A) How will this affect interest rates and explain

Answer 1

The interest rate increases.

Step-by-step explanation:

In a situation like this, whereby the government increases its spending or purchases, thereby making government to be deficit spending. Therefore, to curb or balance the deficit spending, the Treasury must issue more bonds, which in turn will make the price of bonds to be at lower rates, thus, the interest rates increases.

However, as the interest increases, the quantity demanded of private investment reduces, as people will buy more treasury bonds than carry out private investment, this is often referred to as Crowding out.