Final answer:
As a government's debt increases, more resources are allocated to interest payments rather than productive investments. This leads to higher interest rates which can crowd out private investment, undermine consumer confidence, and ultimately hamper economic growth.
Step-by-step explanation:
According to the text, as the level of a government's debt increases, more resources are directed toward payment of interest. This is because government borrowing and its interest payments pull resources away from investments in human and physical capital, which are essential for economic growth. An increase in government borrowing can lead to higher interest rates, as depicted in the example where the equilibrium interest rate shifts from 5% to 6%. These higher interest rates can crowd out private investment since they make borrowing more expensive for businesses, thus reducing investments in physical capital. Furthermore, a growing budget deficit can cause uncertainty in the financial markets and may force the government to resort to inflationary measures to reduce the real value of debt, which in turn can damage consumer confidence and reduce real wealth.