Suppose the government finances a budget deficit by issuing money (selling bonds to the Federal Reserve). This method of finance will:

Question

Quizplus · Accepted Answer

When the government finances a budget deficit by issuing money, it results in an increase in the money supply which leads to a decrease in interest rates. This makes it cheaper for firms and households to borrow money which will increase investment and consumption. Therefore, the expansionary effects of the deficit are enhanced by the expansionary effects of the increased supply of money, leading to a significant increase in aggregate demand. Option A is incorrect because the decrease in interest rates will lead to an increase in investment. Option B is incorrect because households are not necessarily going to save more in anticipation of future taxes. Option C is incorrect because an increase in the money supply will not directly impact aggregate supply.

Suppose the Government Finances a Budget Deficit by Issuing Money