Question

How would you expect larger budget deficits to affect private sector investment in physical capital? Why?

Short answer

Increased budget deficits boost capital demand, which raises interest rates and raises the cost of private sector investment.

Step-by-step solution

Definition

Budget deficit:

A budget deficit arises when spending exceeds receipts, and it shows a country's financial health. When the government refers to spending rather than businesses or individuals, it is referred to as a deficit. The debt is made up of accumulated deficits.

Explanation

Increased budget deficits boost capital demand, which raises interest rates and raises the cost of private sector investment. When countries have budget deficits, they usually have to borrow money to cover them. When governments borrow, they compete with everyone else in the economy for the limited amount of accessible savings. The real interest rate rises as a result of this rivalry, while private investment falls.