When a government runs an Expansionary Fiscal Policy with a large Fiscal Deficit funded through heavy sovereign market borrowings, what adverse impact can occur in the financial markets?

[ A ]The national debt instantly vanishes, causing all corporate bonds to convert into physical cash.

[ B ]Heavy government borrowing absorbs available loanable funds, pushing up domestic interest rates and 'crowding out' private corporate borrowers from accessing capital.[ CORRECT ]

[ C ]The central bank is forced to reduce the money supply to zero, eliminating all bank deposits.

[ D ]Private sector corporate borrowing costs drop to exactly zero percent per annum.

Takeaway

Option B is correct: Heavy government borrowing absorbs available loanable funds, pushing up domestic interest rates and 'crowding out' private corporate borrowers from accessing capital.

Derivation

An expansionary fiscal policy (increased government spending and/or lower tax rates) widens the fiscal deficit (excess of total expenditure over non-debt revenue). To finance this gap, the government issues large volumes of government bonds (G-Secs). In domestic credit markets, massive sovereign borrowing absorbs a large share of investible savings, driving up benchmark bond yields and interest rates. This makes capital scarcer and more expensive for private businesses, a phenomenon known as the 'crowding-out effect'. This tests fiscal policy analysis. The common trap is assuming high public debt lowers borrowing costs.

Why the others fail

A — The national debt instantly vanishes, causing all corporate bonds to convert into physical cash.

Heavy sovereign borrowing increases total national debt obligations rather than making debt disappear.

C — The central bank is forced to reduce the money supply to zero, eliminating all bank deposits.

Government bond issuances do not eliminate bank deposits or reduce the systemic money supply to zero.

D — Private sector corporate borrowing costs drop to exactly zero percent per annum.

Heavy sovereign borrowing increases competition for credit, pushing corporate interest rates upward rather than reducing them to zero.