Why does decreasing debt cause the interest rate to decrease?

It is just simple that when the government demand for money to finance the deposit declines,interest rate will decline. On the contrary, if the debts increase, the government needs to borrow more from the public and has to raise the interest rate to lure the private fund which we know as a crowding out effect. But in the case of the US, the debts have increased substantially(over 100% of GDP now), but interest rate remains low.

That is the thing you have to ask because it is not normal. The answer is QE,means the government did not borrow from the public,but the FED so that the FED can keep the fund rate near zero,and will be until the end of 2013. It's called also printing of new money.

Government debt (bonds) are also subject to supply-demand by investors. By reducing debt, the number and amount of those bonds decrease, which is a decrease in supply. Interest rate is an inverse to bond demand; that is if bonds are in demand in a smaller supply, the required rate of return on them decreases.So, in a contracted restatement of this, decrease of debt caused interest rates to decrease.

Adding, the money supply, which is not affected by the bonds very much, actually has an impact on inflation. This is a case of increasing prices and inflation, and decreasing bond yields, increasing the spread between them. Classical economics was given a new spin for spiral inflation in the late 70's-80's.

There has to be new ways of understanding these things now again. PS - If you are in school, they may or may not be giving you the latest events. This may be what the teacher-professor is looking for.

Well, it's not a fact... and it's not even a valid idea. Look at Japan, the debt is enormous -- 200% or so -- and they can borrow long term around 1%. No sudden crowding out, no bond vigilantes suddenly driving their borrowing costs sky high.

If you want it straight forward, UK was up to nearly 270 or so percent of their GDP in 1945... they even ran a huge debt level in the 19th century, mostly due to warfare. They're at historical low since like the early 60's. Empirically speaking, apparently, this doesn't add up.

If your teacher tells you that, he's either willing to see you write the neoclassical argument down or, if he truly believes this... well, change course 'cause he's a deluded lunatic. The idea is well resumed by the IS-LM model, if you want to look up here: en.wikipedia.org/wiki/Crowding_ou… It shows very simply why some thought of it as reducing private spending and why others didn't. It also shows why fiscal policy does work to some degree.

(i think neoclassical model) says that government deficits decrease savings because the government must head to the loanable funds market to fund the deficit. This is what is referred to as the crowding out effect. A decrease in savings (supply of loanable funds) will result in an increase in the interest rate.

Think about the oppositie of that situation and what happens, although I haven't really looked at causation in the opposite direction.

This works for individuals, states, and businesses but not for the federal government. This is because the neoclassical model no longer applies to our currency as the US is no longer a convertable currency but now a free floating fiat currency. The fed is the bond markets whipping boy.

Notice the stellar correlation between the feds target rates and the treasury rates all the way out. The crowding out theory has been proven incompatible with our current system as well. This misunderstanding is the cause of many problems.

The US does not have to worry about insolvency they only need to worry about inflation and the productive capacity of the US economy. Europe is also struggling with this as when they formed the Euro, all the nations gave up their monetary soveriegnty and without a further union they will continue to struggle as their is no mechanism to balance the trade inbalances between the member states.

I cant really gove you an answer,but what I can give you is a way to a solution, that is you have to find the anglde that you relate to or peaks your interest. A good paper is one that people get drawn into because it reaches them ln some way.As for me WW11 to me, I think of the holocaust and the effect it had on the survivors, their families and those who stood by and did nothing until it was too late.