The Interest Rate Connection Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? In Figure 31.8, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP. The graph plots the downward-sloping demand and upward-sloping supply of financial capital. The y-axis is the interest rate (also known as the "price" of financial capital) and the x-axis shows the quantity of financial capital as a percentage of GDP. An increase in government borrowing increases the quantity of financial capital demanded at all interest rates. This is a rightward shift in the demand for financial capital. The graph shows that the equilibrium interest rate will rise. Figure 31.8 Budget Deficits and Interest Rates In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing