The U.S. Federal government has been running deficits in the hundreds of billion

Question

The U.S. Federal government has been running deficits in the hundreds of billions of dollars which means that the U.S. Treasury is issuing hundreds of billions of dollars in new Treasury securities. If this is all you consider, what are the consequences for interest rates, spending financed by private borrowing, the money supply, the bond supply and inflation from this action alone? While the U.S. has been running these massive deficits, what has been true about interest rates? How do you explain this contradiction in interest rate effects and what are the big concerns going forward?

Explanation / Answer

1.As due to deficit government is issuing billions of dollars which means supply will be more where demand for the currency gets reduced.

2. Due to this the interest rates will be less as the demand will be less and supply will be more. this is in general terms. actually federal government releases more money in to the economy through banks which can be possible by issuing the currency to banks at less interest rates.

3. Coming to the bond supply the federal government purchases the government bonds fom the commercial banks to increase money supply and if government decides to decrease money supply it purchases backs the bonds.

4. more supply and less demand results in reduction of prices which results in increase in the purchasing power. when coming to the inflation part when the economy is in recession then to get use the unemployed resources in the economy money supply gets increased where it unlikely to cause inflation. but in normal economic circumstances if money supply is more than real output then it will cause inflation.

5. dollar rate gets affected due to inflation and interest rates

example

let 1$ = 60rupee

situation 1:-

interest rate = 5% in US and 10% in India

after 1year 1$ will be

1$(1 + interest rate) = 60 (1+ interest rate)

=> 1$ (1 + 0.05) = 60 (1 + 0.1)

1$ = 62.85

situation 2:-

interest rate = 8% in US and 10% in India

after 1year 1$ will be

1$(1 + interest rate) = 60 (1+ interest rate)

=> 1$ (1 + 0.08) = 60 (1 + 0.1)

1$ = 61.11

by analysing both the situations we can see that in situation 1 we have to pay more amount in indian currency to get 1$ as its interest rate is low where as in situation 2 we have to pay less as interest rate increases.

so due to decrease in interest rates due to money supply the dollar gets stronger in the market.

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