Because fiscal policy affects the quantity that the government borrows in financial capital markets, it not only affects aggregate demand—it can also affect interest rates. In the chart below, the original equilibrium (E₀) in the financial capital market occurs at a quantity of $800 billion and an interest rate of 6%. However, an increase in government budget deficits shifts the demand for financial capital from D₀ to D₁. The new equilibrium (E₁) occurs at a quantity of $900 billion and an interest rate of 7%.

A consensus estimate based on a number of studies is that an increase in budget deficits (or a fall in budget surplus) by 1% of GDP will cause an increase of 0.5–1.0% in the long-term interest rate.

When a government borrows money in the financial capital market, it causes a shift in the demand for financial capital from D₀ to D₁. As the equilibrium moves from E₀ to E₁, the equilibrium interest rate rises from 6% to 7% in this example. In this way, an expansionary fiscal policy intended to shift aggregate demand to the right can also lead to a higher interest rate, which has the effect of shifting aggregate demand back to the left.

Related Topics

• What is Government Spending?
• Autonomous Spending
• Autonomous Consumption
• Fiscal Policy
• Expansionary Fiscal Policy
• Contractionary Fiscal Policy
• Progressive vs Regressive Tax
• Marginal Tax Rates
• Proportional Tax
• Trickle Down Theory
• Discretionary Fiscal Policy
• Automatic Stabilizers
• Effects of Discretionary Policy (Interest Rates & Lags)
• Crowding Out Effect 
• National Debt
• Government Borrowing
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• Ricardian Equivalence
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• National Debt
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• Austerity
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• Stabilization Policy
• Robin Hood Effect
• Ricardo Barro Effect
• Automatic Stabilizers
• Standardized Employment Budget
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• Types of Lag in Fiscal Policy
• Temporary and Permanent Fiscal Policy
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• Fiscal Policy Affects Investment and Economic Growth
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• Government Investment in Physical Capital
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• Economic Cycle or Business Cycle
• Business Cycle Indicator
• Peak and Trough
• Recession and Depression
• Hard Landing vs Soft Landing
• Economic Bubble
• Boom and Bust Cycle
• Great Depression
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• Skyscrapper Effect (Economics)
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• Endogenous Growth Theory
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