Answer the following question to receive credit: A government reduces its budget

Question

Answer the following question to receive credit:

A government reduces its budget deficit, hut at the same time people become concerned that the outlook for future government expenditures and revenues increase the chance it will default. Which of the following is correct? a. The reduced budget deficit will raise interest rates in general. The increased risk of default will raise interest rates on government bonds. b. The reduced budget deficit will raise interest rates in general. The increased risk of default will reduce interest rates on government bonds. c. The reduced budget deficit will reduce interest rates in general. The increased risk of default will raise interest rates on government bonds. d. The reduced budge: deficit will reduce interest rates in general. The increased risk of default will reduce interest rates on government bonds.

Explanation / Answer

Answer : a.

Explanation

Using IS-LM framework.

Reduced deficit means (Govt expenditure - tax revenue) has decrease.

As Y = C + I + G

Money Supply = Money Demand

Money Demand = eY -fi

where e,f are constants

Y is net output

C is consumption. C = c(1-t)Y

I is investment. I = I0-di

G is Govt. Expenditure

i is rate of interest.

Increase in taxes or reduction in Govt. Expediture reduces Y and increase r.

Also due to increased chances of Govt. default will make govt. bonds risky, thus increasing their interest rate

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