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If the federal government has a budget surplus and uses it to reduce the size of the national debt, interest rates would be expected to
(a) remain the same.
(b) increase.
(c) decrease.
(d) change in a manner that can’t be predicted without more information.
(e) increase only if the shift in the demand curve is larger than the shift in the supply curve.

2 Thoughts on Using budget surplus to reduce size of national debt, interest rates?
  1. Reply
    August 10, 2011 at 1:15 am

    If the government uses its surplus to reduce the size of national debt, it is effectively increasing the supply of liquid cash. By the elementary laws of supply and demand, an increase in supply will lead to a fall in price (in this case, price being the interest rate). So interest rates will decrease: answer (c)

  2. Reply
    August 10, 2011 at 2:10 am

    The standard argument here is that federal government borrowing causes “crowding out” of private sector investment by raising the interest rate:
    That would mean that a decrease in government borrowing (i.e. paying off some of the debt) would reduce crowding out and hence reduce interest rates.

    However, the crowding out argument only makes sense when the economy is at full employment. When the economy is not at full employment and the banks have plenty of money to lend, crowding out should not occur so there should be no effect on interest rates.

    Thus, we have the new government in the U.K. claiming to reduce the debt with major austerity measures; the U.K. interest rates already at a record low (0.5%); and so there is no reason to expect interest rates to change.

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