Which word is they referring to in the following sentence?
Children make circles because they are perfect.
Is it referring to Children or circles? And why?
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Grammatically, "they" could refer to either "children" or "circles", but as the comments suggest, "circles" makes much more sense. The only way to be sure, however, is through additional context. Consider a sentence with the same form, but different content:
Angels make prophecies because they are perfect.
Now "they" seems more likely to refer to "Angels".
In the general case:
Xs make Ys because they are perfect.
there is no way to tell the referent of "they" without additional context.