1. leads to a better functioning human capital market when the existing stock of debt is not too large.
2. always improves the market for human capital.
3. leads to an increase in aggregate spending apart from whether it makes the market for human capital more efficient.
4. leads to the effects indicated in both 1 and 3 above.
Choose the correct option.
Option 4 is the correct one. If there is no initial stock of government debt the introduction of some debt (in return for a tax cut) will certainly give some members of the community an opportunity to borrow from others at a more favorable interest rate than possible in the private market. Efficiency is improved by compensating for the lack of collateral for loans against human capital. There is some stock of government debt so large, however, that the risk of default outweighs any benefit that can be achieved in terms of human capital market efficiency. An expansion of debt beyond this point would not improve welfare. In any case, the borrowing opportunities afforded by increased government debt will favorably affect aggregate demand by inducing at least some of those who are liquidity constrained to buy consumer durables.
As the stock of government debt gets larger and larger, the interest rate that the government will have to pay to get people to hold it will increase. This is because those who have to pay the interest on that debt have political power and can potentially pressure the government into inflating the real value of the government debt away---as the price level goes up the real value of the interest that must be paid to service the national debt, and the real value of the debt itself, gets smaller. One could imagine the interest rate on the government debt becoming greater than the consumer loan rates at which private market borrowing against human capital occurs. Even if this happened, however, there would be individuals who would use the proceeds of the tax cut to maintain their stock of consumer durables.
Option 2 is not a good choice because the government compensates for the failure of the market for human capital but does not improve the functioning of that market.