Question

Hi I need your answer for these parts a and b for this quistion below. BR/Ha

Question :Debt dynamics.

a. Derive an expression for how the primary budget balance as a share of GDP and the existing debt-to-GDP ratio affect the change in the current debt-to-GDP ratio.

b. Use the equation derived in question a. to discuss what is required to stabilize the debt ratio. Explain the trade-off that governments face when contemplating debt stabilization.

Answer 1

The stabilization of debt to GDP depends on four factors, growth rate of the economy (g), interest rate (r), previous debt to GDP ratio and primary deficit. To keep debt to GDP ratio stabilized, the government should run a primary budget surplus and/or high growth rate of the economy. This means the government should spend more to boost demand or increase taxes to run a surplus. If the government runs a surplus this will lead to falling in consumption and low capital formation and hence low GDP growth rate. If the government spend more to boost demand primary deficit will rise to increase existing debt. Then the government faces a dilemma between these two policies to stabilize debt to GDP ratio.