Question

In times of deflation, the government’s budget deficit is _________because government expenditure includes the __________interest payments on government debt.

Select one:

a. overstated, nominal

b. overstated, real

c. understated, real

d. understated, nominal

Answer 1

Deflation implies a fall in price level.

When price level falls then real value of money increases.

In such scenario, government deficit would be lower in real terms relative to its value in nominal terms.

When value in nominal terms exceeds the value in real terms then a variable is overstated. The interest payments made by government is always in nominal terms.

So,

In time of deflation, the government's budget deficit is overstated because government expenditure includes the nominal interest payments on government debt.

Hence, the correct answer is the option (a).