A government plans to borrow Rs. 20 lakh crore for a large infrastructure project. Discuss how this borrowing might affect the short‑term domestic interest rates and the rupee exchange rate, citing concepts such as crowding‑out and capital outflows.
Answer
Higher borrowing tends to raise domestic interest rates and may depreciate the rupee in the short run due to crowding out and capital outflows.
Step-by-step solution
- Step 1: Explain the crowding‑out effect: increased government borrowing raises demand for loanable funds, pushing up interest rates.
- Step 2: Higher interest rates can attract foreign capital, but if the borrowing is perceived as unsustainable, investors may pull out, causing capital outflows.
- Step 3: Capital outflows increase supply of rupees in the foreign exchange market, exerting downward pressure on the rupee’s value.
- Step 4: Thus, in the short run, domestic interest rates rise and the rupee may depreciate as a result of the large borrowing.
Common mistake: Assuming borrowing automatically strengthens the currency or ignoring the crowding‑out mechanism
Concept tested: Effect of borrowing on interest rates and exchange rates
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