Effects of federal deficits

Effects of federal deficits

  1. Effects of federal deficits on private domestic investment

Federal government deficits affect private investment in an indirect manner, in any economy, capital investment is always a scarce resource hence government issues bonds as a way to pay for a deficit through the funds which would otherwise be used for private investment. In any case, federal government opts out a policy to increase taxes to pay for a deficit. Additional funds on the other hand will discourage private investments. Furthermore if the debt is converted to monetary terms the consumer’s cost of living standard will increase since they will be forced to eat from their investments and saving.

  1. a) Effect of the federal government raising the discount rate on aggregate demand curve

An increase in the discount rate causes the aggregate demand curve to shift to the left. This is because if the government increases the interest rate, individual households will shy off from borrowing cash from the commercial banks and rather use the money to buy goods. This otherwise causes the demand for loanable funds to decrease hence causing a left ward shift in the aggregate demand curve. Changes in interest rate for example affects capital investments especially when interest levels increase, it increases cost of borrowing which reduces capital investments resulting to decline in the aggregate demand and vice versa.

  1. b) Effect of price level increase on aggregate demand

Market prices for goods and services are more hypothetical since there’s no uniform price for most of the goods and services in the economy. Price levels are only important when comparing real price levels of goods against the purchasing power of money. Though an increase in price tends to decrease demand for a good, it is also argued through increasing nominal prices as critical in future economic demand. An increase in demand of a good will only increase the market prices however, that doesn’t  increase the real prices of the goods and services hence changes in price levels has little or no effect on the aggregate demand curve.


  1. c) Effect of the federal government decreasing income taxes on the aggregate demand curve.

If the government decides to lower income tax rates, it will be without doubt stimulating economic growth in the long run.  However, lowering tax rates results in an increase in after tax return to saving, investment and work. It would also increase after tax income which people receive from their employment hence decreasing the need to work, save and invest. Decrease in tax rate shifts the aggregate demand curve on the right since it increases the people’s incentive to work.

  1. d) Effect of increasing investment spending on the aggregate demand curve.

Under ceteris paribus, if the firms increase their investment spending, this directly increases the aggregate demand causing a right ward shift. An increase in investment increases productivity which enables an increase in aggregate demand.

  1. e) Effect of increasing inflation by 6% on the aggregate demand.

Inflation relates to the general increase in price of goods and services in the economy. An increase in price levels will only lower the demand for a good or a service since it only affects the market prices hence an increase in inflation will not cause a shifts in the aggregate demand curve.

  1. f) Effect of federal government decreasing purchases in an effort to reduce federal deficit

One of the key expenditures that make up the aggregate demand is Government expenditure. Therefore a federal deficit change due to government purchases leads to a change in aggregate demand. This means that a larger deficit increases aggregate demand while a smaller deficit decreases aggregate demand. A decrease in government purchases responds directly with a decrease in aggregate demand. This results to an increase in tax which reduces amount of disposable income available to each households causing a left ward shift in the aggregate demand curve.

  1. g) Effect of federal government engaging in open market operations by selling treasury bonds on the aggregate demand curve

Selling of treasury bonds in open market operations takes them off the market. However amount spent with the purchases increases amount of money available in the economy. The amount of money added is more than what can be spent. The amount spent will cause an increase in aggregate demand curve causing a right ward shift.

  1. i) Effect of changing law requiring banks to hold a larger percentage of total deposit on the aggregate demand curve

If the federal government passes a law requiring the bank to hold a larger percentage of their total deposits, money supply as a result will decrease making the interest rates to increase and an increase in interest rates discourages investments causing the aggregate demand to decrease at any given price level.

  1. a) In the short run, aggregate demand increases hence both price levels and GDP increases. Also if aggregate demand decreases in the short run both GDP and price levels will fall. A reduction in aggregate demand will result to a reduction in investment. Price levels falls causing the output also to fall hence the economy is at price level output combination where the GDP is below the potential. Holding all factors constant, a change in price levels result to changes in the amount of goods and services supplied causing a shift in the supply curve.
  2. b) An increase in government spending will raise the aggregate demand for goods and services causing a rightward shift hence an increase in consumer income. Likewise a decrease in federal taxes raises the individual income which increases the consumption demand for the people
  3. c) In an economy operating far from the full capacity, only the final prices of the good adjusts whereas cost factors do not. The resources are scarce and the economy produces at far beyond full employment levels hence low consumer income. There’s general increase in price which causes households which causes owners to demand for high prices hence will cause inward shift of the aggregate demand in the short run.

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