An increase in government deficit will lead to an increase in aggregate demand for goods and services which in turn increase GDP and prices of goods over time. This means that there is inflation and an increase in income. These changes will lead to a change in interest rate, which can be explained with the income effect, price-level effect and the expected-inflation effect. An increase in money supply as an expansionary monetary policy to cope with the rising deficit will raise national income and wealth. Hence, demand for money, as a store of value or medium of exchange will increase. This shifts the money demand curve to the right, from Md1 to Md2 (Figure 3) in the money market. This resulted in an increase in interest rates from I1 to I2. Businesses are also more willing to borrow to invest as they have more profitable investment opportunities for which they need financing. This leads to an increase in supply of bonds, shifting the supply curve of bond to the right from Bs1 to Bs2 (Figure 4). The theory of asset demand states that demand for bonds will increase when there is a business cycle expansion that brought about an increase in wealth. This will result in a rightward shift of the demand curve for bonds from Bd1 to Bd2. Given that both the demand and supply curve for bonds shift right, the change in price is ambiguous as we do not know which curve shifted more because in this question, the government issued new bonds to cope with the deficit. In Figure 4, it is assumed that the shift of the supply curve dominates that of the demand curve. Hence, the price for bond will fall from P1 to P2 and since price of bond is negatively related to interest rates, interest rates increased.
Thus, the income effect of a rise in money supply is an increase in interest rates due to an increase in income and wealth.
An increase in price level due to increasing government deficit will...
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