Budget Deficits and Increase in Interest Rates

How future generations are affected by deficits

Budget deficits result into an increment in the interest rate. This arises from the fact that the government increases its borrowing from the public by issuing securities such as bonds and treasury bills so as to seal the deficit. To attract investors, the government increases the interest rate payable on the securities. This means that the government will be required to pay more to the investors. To achieve this, the government may intend to increase its revenue collection by increasing the tax rate. This means that the future generations will be burdened by the requirement to pay higher taxes.

Increase in the rate of interest on securities causes other interest rate to increase. The resultant effect is crowding-out of private investors. According to Baumol and Blinder (694), crowding-out refers to a decline in private investment due to the prohibitive interests rates which limit their repayment ability. Reduction in the volume of private investments results into a decline in the economy’s production capacity. In the long-run, the rate of economic growth will slow down culminating into a decline in the rate at which new jobs are created. This means that future generations may suffer due to increment in unemployment rate.

However, budget deficit within an economy may enhance the rate of economic activity. This phenomenon is referred to as the crowding-in effect (Baumol & Blinder 694). Budget deficit may stimulate the rate of economic activity. This arises from the fact that the government may increase its deficit spending in order to stimulate the economy. As a result of induced investment as businesses may try to make more profit by meeting the existing consumer demand. According to Baumol and Blinder (694), increase in government spending leads into growth in an economy’s real GDP. This means that the living standards of future generations will be improved.

Effect of increase in interest rate on the foreign exchange rate of the dollar relative to other currencies

There is a strong correlation between the rate of interest and inflation. The US government can reduce the rate of inflation by increasing the rate of interest. When the rate of interest increases, it becomes more profitable for US financial institutions. The high interest rate will attract more foreign capital. This arises from the fact that the financial securities such as corporate bonds issued by the domestic will be more appealing to foreign investors. This leads into an increment in demand for US dollars amongst foreign investors which culminates into a rise in the exchange rate of the dollar relative to other currencies.

How raising interest rate affects US exports and domestic output in other countries

There is an indirect relationship between the exchange rate and net exports (Taylor 291). From the above analysis, an increase in interest rate leads into a rise in the exchange rate. This means that it becomes expensive for foreigners to import goods from the US since they will be required to exchange more amount of their local currency to one unit of the US dollar. The resultant effect is that the US net exports will be reduced significantly due to decline in market. On the other hand, it becomes relatively cheap for US consumers to import goods from foreign countries. This means that domestic output of the foreign countries is increased.

Works Cited

Baumol, William and Blinder, Alan. Economics: principles and policy. Mason, OH: South-Western Cengage Learning, 2009. Print.

Taylor, John. Principles of microeconomics. Boston: Houghton Mifflin, 2006. Print.

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