Canadian Securities Course (CSC) Level 1 Practice Exam

How does the demand and supply of capital affect interest rates?

1. A decrease in demand for capital leads to lower interest rates

2. Rising demand for capital causes interest rates to fall

3. A large government deficit or a business boom raises the demand for capital and causes interest rates to rise

4. Interest rates are not influenced by capital supply and demand

The correct answer is: A large government deficit or a business boom raises the demand for capital and causes interest rates to rise

The correct choice highlights how increased demand for capital, such as that driven by a large government deficit or a business boom, results in higher interest rates. When demand for capital rises, lenders recognize that borrowers are competing for a limited amount of available funds. As demand outstrips supply, lenders can increase the cost of borrowing, which manifests as higher interest rates. In scenarios where the government runs significant deficits or businesses are expanding rapidly, there is an increased appetite for borrowing. This uptick in borrowing leads to upward pressure on interest rates because lenders seek to allocate their resources to the highest bidders or to manage the increased risk associated with lending in a more volatile economic environment. The other options do not accurately reflect how the balance of capital supply and demand affects interest rates. For example, decreased demand for capital naturally leads to lower interest rates, as lenders would have to offer more attractive rates to attract borrowers in a less competitive environment. Rising demand for capital causing interest rates to fall is a misunderstanding of the relationship; typically, rising demand leads to rising rates, not the opposite. Lastly, the assertion that interest rates are unaffected by capital supply and demand overlooks the fundamental principles of market dynamics where interest rates are a primary mechanism for balancing these forces.