Rising public debt levels at constant interest rates increase the volume of interest servicing payments that have to be made. For a sovereign nation entrenched in recession, these payments will
Answer: not reduce the room $-for-$ for other non-inflationary discretionary deficit spending because increasing imports will keep opening the spending gap that has to be "filled".
The best answer is Option (c) - not reduce the room $-for-$ for other non-inflationary discretionary deficit spending because increasing imports will keep opening the spending gap that has to be "filled"..
Note: the question really only relates to sovereign governments issuing their own currency and floating it on foreign exchange markets. Further, the "best" descriptor is that this answer is the general case, applying to situations where there is excess productivity capacity available as well as situations where there is full employment.
Even Post Keynesian deficit doves often state that once the public debt ratio gets "too big" the interest servicing payments will start to swamp aggregate demand and "reduce the room $-for-$ for other non-inflationary discretionary deficit spending because they will fill up the spending gap more quickly."
It is an often-stated worry. It is possible this could happen and then the government could just increase taxes to ensure that aggregate demand remained within the capacity of the real productive sector to respond to it. But if there is excess capacity, then interest payments (or any spending in general) pose no inflation risk and they will help growth and so this option is incorrect.
You might have also thought the rising interest servicing payment would reduce the capacity of the private sector to save because they will require cuts backs in the deficit to support the repayments. So in one sense, this would reflect a correct interpretation of net public spending whereby it supports non-government saving because it adds to aggregate demand which generates income and saving is a function of the latter.
So, under pressure to contain the consequences of a rising debt ratio governments and an erroneous belief that the rising payments have to "funded" would require some discretionary reductions in the deficit. But the fallacy here is that a sovereign government is never revenue constrained because it is the monopoly issuer of the currency and doesn't need to fund any expenditure.
In this regard, the interest servicing payments are no different conceptually to building a school or paying a pension. All are government spending and all are transacted in the same way (depending on specific institutional machinery that governments put in place which might hide the reality of this point).
So the best option presented is that relating to the open economy effects as above. Total aggregate demand is conceived in macroeconomics as being derived from various sources of spending which then equal total output = total income = GDP. We write it in symbols as:
GDP = C + I + G + (X - M)
which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X - M).
Imports are considered, in part, to be positively driven by national income - so a proportion of every dollar that is produced within the economy goes to imports. Imports are thus considered a "drain" on aggregate demand because the income that is created within the domestic economy is lost from the domestic expenditure stream - it goes abroad.
Imports are always draining demand.
If the interest servicing payments are not all saved - thus adding to aggregate demand then GDP will be stimulated by them. Saving will drain some of the increased spending capacity as will taxation. But some of the GDP growth will drain to imports and reduce inflationary pressures that might occur.
There are also other possibilities. The non-government sector income derived from the interest servicing payments may stimulate new investment as aggregate demand increases. New investment creates new productive capacity and economic growth increases.