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CFA Level I Exam · Fiscal Policy

Government Deficits and Public Debt for CFA Level I

Updated 7 October 2026 · Fact-checked

A budget deficit arises when government spending exceeds tax revenue. The gap is financed by borrowing, which adds to public debt. Debt is judged by the debt-to-GDP ratio. The ratio is stable when the primary surplus equals (r − g) × D/Y. When g > r, a primary deficit of up to (g − r) × D/Y can be run while keeping the ratio stable.

Understand Government Deficits and Public Debt

A fiscal deficit is the amount by which government spending exceeds revenue in a period. A surplus is the opposite. Public debt is the stock built up by past deficits. The deficit is a flow. The debt is a stock. Mixing them up is a classic trap.

A government can finance a deficit in three main ways. It can borrow from domestic savers, borrow from foreign investors, or borrow from the central bank, which creates new money. Borrowing from savers is the usual route. Financing through money creation can raise inflation.

The crowding-out effect says heavy government borrowing competes with private borrowers for savings. This can push interest rates up and reduce private investment. The effect is stronger when the economy is near full employment. In a deep recession, with idle savings and weak private demand, crowding out is smaller.

A deficit is not bad in itself. What matters is whether the debt-to-GDP ratio is stable. Debt grows with interest costs and new borrowing. GDP grows with real growth and inflation. If nominal GDP grows faster than debt, the ratio falls. If debt grows faster, the ratio rises.

High debt carries risks: higher interest costs, less room for stimulus, and possible loss of investor confidence. Countries borrowing in their own currency can face inflation instead of outright default. Countries borrowing in a foreign currency face tougher limits. Ricardian equivalence argues that private saving rises to offset government dissaving, because people expect higher future taxes. So deficits may not raise total demand. Most analysts treat this as only partly true.

Key formulas to remember

Budget balance
Deficit = Government spending − Tax revenue
A positive result is a deficit. Spending includes interest on existing debt.
Primary balance
Primary balance = Revenue − (Spending excluding interest)
Shows the budget position before the cost of past debt.
Debt-to-GDP ratio
Debt ratio = Public debt ÷ GDP
Main measure of debt burden. Use nominal values for both.
Debt ratio stability condition
Ratio rises if (r − g) × (D/Y) + (primary deficit/Y) > 0
r = interest rate on debt, g = nominal GDP growth, D/Y = debt-to-GDP. Ratio is stable when this sum equals zero, and falls when it is negative. This is a first-order approximation.
Rule of thumb
If g > r, a country can run a primary deficit of up to (g − r) × D/Y and keep the ratio stable
A larger primary deficit still raises the ratio. If r > g, a primary surplus is needed to hold the ratio steady when debt is positive.

How to solve Government Deficits and Public Debt questions

Use the same sequence for any question on deficits, financing, crowding out or sustainability.

  1. 1Identify whether the question is about a flow (deficit) or a stock (debt).
  2. 2Check whether interest is included. Decide if the figure is the overall or the primary balance.
  3. 3If it asks about financing, name the source: domestic borrowing, foreign borrowing or money creation, and its main effect.
  4. 4For crowding out, judge the state of the economy. Near full employment means stronger crowding out. In a slump it is weaker.
  5. 5For sustainability, compare the interest rate r with nominal growth g. Use the same time basis for both.
  6. 6Apply the debt ratio condition and compute the required primary balance if asked.
  7. 7Eliminate the two options that confuse stock with flow, or reverse the r and g comparison.

Quickest way: The r versus g shortcut

When to use it: Use it for any sustainability question that gives an interest rate and a growth rate.

  1. Compute r − g.
  2. If r − g is negative, debt tends to shrink relative to GDP. A primary deficit of up to (g − r) × D/Y is consistent with a stable ratio.
  3. If r − g is positive, multiply it by the debt ratio. That is the primary surplus (as % of GDP) needed to stabilise the ratio.
  4. If the question asks for the ratio change, add this to the primary deficit ratio.
  5. Check the sign of your answer against common sense before choosing.

Common mistakes in Government Deficits and Public Debt

  • Treating the deficit and the debt as the same thing.

    Both are in currency units and the words sound alike.

    Fix: Remember deficit is a yearly flow and debt is the accumulated stock. Deficits add to debt.

  • Saying crowding out always happens.

    Students memorise the effect without its conditions.

    Fix: Link it to the economy's state. It is strongest near full capacity and weaker with idle resources.

  • Using real growth with a nominal interest rate.

    Both rates are given and look comparable.

    Fix: Compare nominal r with nominal g, or real r with real g. Never mix them.

  • Ignoring interest when judging the primary balance.

    Students read 'balance' as the overall figure.

    Fix: Primary balance excludes interest payments. Add interest back to get the overall deficit.

  • Assuming a deficit always means unsustainable debt.

    Deficits sound bad in general.

    Fix: If g exceeds r, a primary deficit of up to (g − r) × D/Y still keeps the debt ratio stable. A larger one raises it.

Worked examples

Example 1

A government has debt of 80% of GDP. The interest rate on debt is 5% and nominal GDP growth is 3%. What primary surplus, as a percentage of GDP, keeps the debt ratio stable? Options: A) 0.8% B) 1.6% C) 2.4%

Show the solution
  1. Compute r − g = 5% − 3% = 2%.
  2. Multiply by the debt ratio: 2% × 0.80 = 1.6% of GDP.
  3. A primary surplus of 1.6% of GDP approximately offsets the growth in the ratio. The formula is a first-order approximation. The exact form, (r − g) ÷ (1 + g) × D/Y, gives about 1.55%, so B is still the closest option.

Answer: B) 1.6%

Example 2

Which statement about financing a fiscal deficit is most accurate? A) Borrowing from domestic savers can raise interest rates and reduce private investment. B) Financing through central bank money creation is certain to lower inflation. C) Foreign borrowing removes any burden on future taxpayers.

Show the solution
  1. Option B is wrong: money creation adds to the money supply and tends to raise inflation.
  2. Option C is wrong: foreign debt must still be repaid and serviced, so future taxpayers bear it.
  3. Option A describes crowding out, which is a recognised effect of domestic borrowing.

Answer: A

Exam tips

  • Each question has a stem and three options (A, B, C), so spot the stock-versus-flow trap first. It removes one option fast.
  • For r and g questions, multiply (r − g) by the debt ratio. Keep r and g on the same nominal or real basis.
  • If an option says crowding out 'always' occurs or 'never' occurs, it is probably wrong. Look for conditional wording.
  • Know the three financing sources and the main effect of each. Money creation links to inflation.
  • Link this topic to fiscal multipliers and Ricardian equivalence. They are often tested together.

Practice questions from Fiscal Policy

Government Deficits and Public Debt in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Government Deficits and Public Debt: frequently asked questions

How are fiscal deficits financed?

Governments borrow from domestic savers, borrow from foreign investors, or borrow from the central bank, which creates money. Domestic and foreign borrowing add to public debt. Money creation can raise inflation.

What is the crowding-out effect?

It is the fall in private investment caused by higher interest rates when the government borrows heavily. It is stronger when the economy is near full employment. It is weaker during a recession with spare capacity.

How do you judge debt sustainability for CFA Level I?

Look at the debt-to-GDP ratio and compare the interest rate with nominal GDP growth. If growth exceeds the interest rate, the ratio is easier to stabilise, and a limited primary deficit is consistent with a stable ratio. If not, a primary surplus is needed.

What is the difference between a deficit and public debt?

The deficit is the shortfall in one period. Public debt is the total accumulated from past deficits, net of any surpluses. Deficits increase the debt.