Final answer:
The cost of debt increases as the degree of leverage increases because higher leverage signifies greater risk to lenders, leading them to seek higher interest rates to offset that risk. As companies and governments compete for financial resources in rising debt scenarios, the overall cost of borrowing can climb, exerting a contractionary effect on the economy.
Step-by-step explanation:
The cost of debt will begin to increase as the degree of leverage increases. Leverage refers to the amount of debt a company uses to finance its operations and investments. As a business takes on more debt, the risk to lenders increases because there are more claims on the company's cash flow and assets, thus requiring higher interest rates to compensate for that increased risk. Companies with high leverage are viewed as riskier to lenders due to the higher burden of interest payments, especially in a rising interest rate environment when financing government debt also becomes more expensive.
Increasing leverage competes for the same financial resources, driving up the cost of borrowing. This scenario can lead to a contractionary effect on aggregate demand in the economy. Furthermore, high levels of national debt can lead to reduced confidence in the economy, causing investors to demand higher interest rates on both government and corporate debts. Throughout this occurrence, businesses have to navigate carefully to manage their costs and maintain their growth.