Question 64

Budget-deficit borrowing from the public most likely raises interest rates, crowds out investment.

When the government borrows from the public to finance a budget deficit, it typically leads to an increase in interest rates. This phenomenon occurs because the demand for loanable funds increases, which can crowd out private investment as borrowing costs rise.

A) Lowers interest rates

This option is incorrect because budget-deficit borrowing usually increases the demand for funds, which tends to raise interest rates rather than lower them. Lower interest rates generally result from a surplus of funds or decreased borrowing needs, which is not the case when the government is borrowing heavily.

B) Raises interest rates, crowds out investment

This option is correct as it accurately describes the economic principle that increased government borrowing leads to higher interest rates. As the government competes for available funds in the financial market, private investors may find it more expensive to borrow, thus reducing their investment, which is known as "crowding out."

C) Increases exports

This option is incorrect because budget-deficit borrowing does not have a direct impact on exports. While economic conditions influenced by government borrowing can affect trade, the act of borrowing itself does not inherently lead to an increase in exports.

D) Lowers inflation

This option is also incorrect. Budget-deficit borrowing tends to exert upward pressure on interest rates and can lead to increased government spending, which may actually contribute to inflationary pressures rather than lowering them.

Conclusion

The correct answer, that budget-deficit borrowing raises interest rates and crowds out investment, is supported by economic theory regarding the impact of government borrowing on the financial markets. Other options fail to recognize this dynamic, either misrepresenting the effects on interest rates or incorrectly linking borrowing to export levels or inflation trends.