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sunnyjohn · Fri Nov 20, 2009 1:52 am

Conventional wisdom has it that large deficits in the United States budget cause interest rates to rise. Two main arguments are given for this claim. According to the first, as the deficit increases, the government will borrow more to make up for the ensuing shortage of funds. Consequently, it is argued, if both the total supply of credit (money available for borrowing) and the amount of credit sought by nongovernment borrowers remain relatively stable, as is often supposed, then the price of credit (the interest rate) will increase. That this is so is suggested by the basic economic principle that if supplies of a commodity (here, credit) remain fixed and demand for that commodity increases, its price will also increase. The second argument supposes that the government will tend to finance its deficits by increasing the money supply with insufficient regard for whether there is enough room for economic growth to enable such an increase to occur without causing inflation. It is then argued that financiers will expect the deficit to cause inflation and will raise interest rates, anticipating that because of inflation the money they lend will be worth less when paid back.

Unfortunately for the first argument, it is unreasonable to assume that nongovernment borrowing and the supply of credit will remain relatively stable. Nongovernment borrowing sometimes decreases. When it does, increased government borrowing will not necessarily push up the total demand for credit. Alternatively, when credit availability increases, for example through greater foreign lending to the United States, then interest rates need not rise, even if both private and government borrowing increase.

The second argument is also problematic.  Financing the deficit by increasing the money supply should cause inflation only when there is not enough room for economic growth.  Currently, there is no reason to expect deficits to cause inflation.  However, since many financiers believe that deficits ordinarily create inflation, then admittedly they will be inclined to raise interest rates to offset mistakenly anticipated inflation.  This effect, however, is due to ignorance, not to the deficit itself, and could be lessened by educating financiers on this issue.

Q1)It can be inferred from the passage that proponents of the second argument would most likely agree with which of the following statements?

A)The United States government does not usually care whether or not inflation increases.
B)People in the United States government generally know very little about economics.
C)The United States government is sometimes careless in formulating its economic policies.
D)The United States government sometimes relies too much on the easy availability of foreign credit.
E)The United States government increases the money supply whenever there is enough room for growth to support the increase.

Q2)The author uses the term "admittedly" (see highlighted text) in order to indicate that

A)the second argument has some truth to it, though not for the reasons usually supposed
B)the author has not been successful in attempting to point out inadequacies in the two arguments
C)the thesis that large deficits directly cause interest rates to rise has strong support after all
D)financiers should admit that they were wrong in thinking that large deficits will cause higher inflation rates
E)financiers generally do not think that the author's criticisms of the second argument are worthy of consideration

OA: C A

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heshamelaziry · Fri Nov 20, 2009 6:15 pm

Why not E for the first question ? It says in the first para that when they borrow, they they take sufficient consideration of room for economic growth.

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A.Kiran · Fri Dec 11, 2009 6:16 am

Exactly.

E has to be the answer for the first one.

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scoobydooby · Sat Dec 12, 2009 7:45 am

C is correct for the 1st q.

E mentions just the opposite. the govt tends to increase money supply with insufficient regard for whether there is enough room for economic growth=>the govt. may sometimes increase money supply even when there is no room for growth=>the govt. is sometimes careless

insufficient regard is a paraphrase for careless

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duongthang · Sat Dec 19, 2009 11:42 pm

for the second question, why D is wrong?

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