Question51 Government deficit. If international investors begin to doubt the ability for a country to finance spending with ________, markets will demand ________. taxes and borrowing; lower interest rates taxes and borrowing; higher interest rates borrowing; more bonds borrowing; less government spending only taxes; higher interest rates ResetMaximum marks: 1 Flag question undefined

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Question: Government deficit. If international investors begin to doubt the ability for a country to finance spending with ________, markets will demand ________.
Options:
1) taxes and borrowing; lower interest rates
2) taxes and borrowing; higher interest rates
3) borrowing; more bonds
4) borrowing; less government spending
5) only taxes; higher interest rates

Option 1 analysis: Saying that financing with taxes and borrowing would lead to lower interest rates is inconsistent with standard financing dynamics. If investors doubt a country’s ability to finance through taxes and borrowing, they would typically demand higher, not lower, yields to compensate for risk. Therefore this choice misstates the consequence of doubt and misattributes the direction of interest-rate movement.

Option 2 analysis (the correct-looking pairing): The idea is that if investors doubt the country can finance spending via taxes and borrowing, they would require higher compensation for risk, i.e., higher interest rates. This aligns with the core mechanism: increased perceived risk raises required returns, pushing up yields on borrowing. Note the phrasing connects the financing method (taxes and borrowing) with the market’s reaction (higher interest rates).

Option 3 analysis: 'borrowing; more bonds' suggests that doubt would lead to more issuance of bonds, and that markets would react with higher demand for bonds or higher prices. In reality, doubt about financing would more plausibly raise yields, not simply increase the number of bonds issued. The linkage to 'more bonds' does not directly capture the standard market response described in the prompt.

Option 4 analysis: 'borrowing; less government spending' would imply a policy tightening that reduces deficit, but the statement about investors doubting financing does not logically imply that the response is to reduce government spending. It instead centers on the price of borrowing, i.e., interest rates, so this pairing misses the market’s typical reaction to financing doubt.

Option 5 analysis: 'only taxes; higher interest rates' restricts the financing channel to taxes alone, ignoring borrowing as a key tool. In practice, deficits are financed by both taxes and borrowing, so this answer is too narrow and misrepresents the typical mix. The claim that higher interest rates follow from doubt about financing via taxes alone is incomplete and misleading.

Summary of reasoning across options: The scenario describes a loss of confidence in the ability to finance deficit spending through the usual channels (tax revenue and borrowing). Financial markets respond by demanding higher returns to compensate for the increased risk, which translates into higher interest rates on government borrowing. Options that predict lower interest rates, or that misidentify the financing mechanism or the market response, fail to capture this fundamental relationship.

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