Between 2008 and 2016, the U.S. federal budget deficit was in record large deficits. Other things being equal, one effect of these deficits would be:

a. higher interest rates and increased investment.

b. higher interest rates and decreased investment.

c. lower interest rates and increased investment.

d. lower interest rates and decreased investment.

• The correct answer is b. higher interest rates and decreased investment.

One of the main reasons for an existing budget deficit is a recession. In a recession, governments implement an expansionary fiscal policy. As a consequence, the government spends more money than it collects through taxation and other fees. A budget deficit is usually controlled by issuing more government bonds to finance the debt. When there are more bonds in the market their prices fall down. As the prices of bonds fall down there is an increase in the market interest rates. Higher interest rates stimulate savings and decrease private investment since the cost of the money is now higher. Based on this, the correct answer is option b. On the other hand, option a. is incorrect because higher interest rates decrease investment. Options c. and d. are also incorrect since bond prices and interest rates have an inverse relationship.