Question

You are appointed secretary of the treasury of a recently independent country called Rugaria. The currency of Rugaria is the lav. The new nation began fiscal operations this year, and the budget situation is that the government will spend 10 million lavs and taxes will be 9 million lavs. The 1?million?lav difference will be borrowed from the public by selling 10?year government bonds paying 5 percent interest. The interest on the outstanding bonds must be added to spending each year, and we assume that additional taxes are raised to cover that interest. Assuming that the budget stays the same except for the interest on the debt for 10 years, what will be the accumulated debt? What will the size of the budget be after 10 years?

Answer 1

Solution:-

Government Spending(G) = 10 millions.
Taxes= 9 millions.

Budget deficit= Governnment spedning - Taxes
= 10 - 1
= 1 million.
Budget size= 10 millions

1 million bonds were issued at 10 yrs maturity and 5% interest rate.
Future value of this amount of interest is added back to the principal every year.
FV= PV( 1+i)^n

FV= future value
PV present vaue= 1 million
i= interest rate @5%= 0.05

FV= 1 ( 1 +0.05)^10
= 1.63 millions.
1 million bonds will become 1.63 millions after 10 years
Interest amount= 1.63 - 1 million
=0.63 millions.
The interest amount is collected by way of taxes.

additional Taxes = 0.63 millions
this amount should be paid to the bondholders.

So, there will be an increase in budget size by 0.63

Tota budget Size = 10 +0.63
= 10.63 millions

Government spending= 10 millins + 0.63 millions (interest payments)
Revenue= 9.63 + 1 million= 10.63