If debt accumulates too fast and investors start to worry about [ higher risk of

Question

If debt accumulates too fast and investors start to worry about [higher risk of default/ higher government revenues/ reduced risk of default], we can suppose that the [price of the government’s bonds/ the effective real interest rate paid to bondholders] will fall and the effective real interest rate paid to bondholders will [rise/fall]. Of course, if a country must pay a [higher/lower] effective real interest rate paid to bondholders when it issues new debt, that will lead to [an increase/a decrease] in the cost of [private investment/ government investment/ private borrowing/ government borrowing]. The consequence could be [an increase/ a decrease] in the government deficit.

Explanation / Answer

Answer:

Correct sequence of statements will be as follows:

If debt accumulates too fast and investors start to worry about higher risk of default, we can suppose that the price of the government’s bonds will fall and the effective real interest rate paid to bondholders will rise. Of course, if a country must pay a higher effective real interest rate paid to bondholders when it issues new debt, that will lead to an increase in the cost of a government borrowing. The consequence could be an increase in the government deficit.

Explanation:

High debt attracts higher risk of default. Thus, price of the government bond comes down. Now, price of the bond is inversely proportional to the interest rate earned by the investors. Thus, real interest rate will also increase. It causes cost of debt to increase also as it is the required rate of return on debt. Finally, increased payment on borrowings will increase expenses. So, government deficit also increases.

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