Economics question question

Walex

Can someone explain how real interest rates are affected by government borrowing?

"...a reduction in the budget deficit means that government borrowing will decline, which reduces real interest rates and causes investment funds to flow out of the country. As a result, the value of the dollar tends to decline."

Not exactly sure of the relationship here..

zhaoyp

Essentially, the government doesn't need to borrow as much anymore. So they do not need to entice foreign investors with as attractive yields (i.e. US 10 Year Treasury). Foreign investors will begin to look for more attractive yield elsewhere and will sell/convert the dollar to a different currency.

SpyAli

Demand for risk free assets stays the same, supply of risk free assets goes down (government borrows less), yields go down. Low yeilds -> decreased demand for currency -> currency depreciates (holding inflation constant in both countries).

benbenxiong

There is also a relevant topic from L1: "crowding out effect" whereby the government increases real interest rates by heavily borrowing to cover deficits.

This could be also relevant.

profil

not 100% sure i saw an answer to your question though--which was what is hte relationship btwn government borrowing and interest rates

and sadly not 100% sure i know answer, but heres my best guess: in order for the government to be able to borrow (i.e. issue bonds) people have to be incentivized to buy those bonds. people will be more interested in buying those bonds if the govt offers higher rates.

if government no longer needs as much money, they no longer need to offer rates as attractive...

ninja1024

there are plenty of people who want U.S. dollars right now, China, India, etc. granted they are diversifying away from the dollar, but it's still represents a large portion of their reserves. safety of capital is very important when sovereign risk is involved. we're supplying tons, yet demand is still there. case of lesser of two evils...until demand really dorps, then it could get very interesting.



Edited 1 time(s). Last edit at Friday, May 27, 2011 at 12:52PM by jgrandits.

spreads

basically govt would want to borrow to reduce the deficits , and they will borrow at higher yields (lower bond prices) in an auction process, typically the govt at the beginning of the year provides a borrowing calendar wherein it forecasts an expected deficit and expected borrowing .

as well explained by others , the effect of lower deficit makes govt to borrow less which would reduce the supply of bonds in the market thereby lower yields (higher prices) . when the interest rates are lower investors would flee off to , which causes capital outflow and domestic currency depreciation

SFoyil

I think people are missing the obvious (and shorter answer) to your question, which is:

Gov't budget deficits --> gov't competing with businesses for private investment --> increased competition for the money to fund the deficit/investment --> investors will require a higher return.

Your question hits the flip side of that coin.