Question

Here's the question:

Is the ratio of government debt to GDP a useful indicator of a government’s indebtedness?When could it be misleading?

I'm confused with the solution, especially the highlighted sentence:

Debt is a stock and a government liability; GDP is a flow and a potential source of tax revenue. The economic variable that connects real stocks and real flows is the real interest rate. If the real interest rate is low then it is possible to service a much higher level of debt than at high interest rates. If the real interest rate remains constant, changes in the debt /GDP ratio does tell us what is happening to the indebtedness of the government, but if real interest rates doubled, it would take much larger GDP and tax revenue to service any given amount of debt.

Don't we use (r-pi-g) D/PY to indicate the debt burden's effect on this ration? And r indicates nominal interest rate, the lower it is, the problem of inherited debt burden can be reduced. Why the solution says 'service a much higher level of debt than at high interest rates' despite 'the real interest rate is low'?

Could you possibly explain this further? Thank you.

Answer 1

When real interest rate is low the debt can be paid obviously at lower interest and thus can be serviced effectively.

If real interest or nominal interest is high then GDP has to increase such that debt to GDP ratio reduces and thus debt can be serviced at high interest rates.

However ideal scenario is higher GDP and lower interest rates which keep lower debt to GDP ratio and thus debt can be serviced at much lower rate such that overall interest payout is lesser.

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