FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

Fiscal Policy, Public Debt and Sovereign Risk Explained

Q: How does a government deficit affect bond yields?

Larger deficits mean more bond issuance and may raise concerns about debt sustainability. Investors then ask for higher yields to cover default, inflation and supply risk. The effect depends on growth, credibility and who buys the debt.

Q: What is the difference between fiscal policy and monetary policy?

Fiscal policy is government spending and taxation, decided by the government. Monetary policy is the central bank's control of interest rates and liquidity. They interact, and heavy public debt can limit the central bank's freedom.

Q: What causes a sovereign debt crisis?

Common causes are high debt with weak growth, large deficits, heavy short-term or foreign-currency borrowing, and banking-sector liabilities that fall on the state. A loss of investor confidence then raises yields and can make refinancing difficult.

Q: What is debt sustainability?

It means the government can keep servicing its debt without a disorderly adjustment or default. In practice it is assessed through the debt-to-GDP path, which depends on r, g and the primary balance.

Updated 11 October 2026 · Fact-checked

Fiscal policy is the government's use of spending and taxation. Deficits add to public debt. Debt is sustainable when the debt-to-GDP ratio stays stable without drastic adjustment. If markets doubt this, they demand higher yields, which raises interest costs and can start a self-reinforcing sovereign stress cycle.

Understand Fiscal Policy, Public Debt and Sovereign Risk

Fiscal policy is how a government uses spending and taxes to influence the economy. Monetary policy is set by the central bank using interest rates and its balance sheet. Fiscal policy is set by the government and legislature. Both aim at stability, but they use different tools and different decision-makers.

When spending exceeds revenue, the government runs a deficit. It borrows to fund it. The stock of past borrowing is public debt. The primary balance is revenue minus spending before interest payments. The overall balance includes interest. A government can have a primary surplus and still have an overall deficit if interest costs are large.

Debt sustainability asks whether the debt-to-GDP ratio can be kept stable. Three forces drive it: the interest rate on debt (r), nominal GDP growth (g) and the primary balance. If r is above g, debt grows faster than the economy unless the government runs a primary surplus. If g is above r, the ratio can fall even with a small primary deficit.

Fiscal stress reaches markets through yields. Investors price in default risk, inflation risk and the risk that supply of bonds overwhelms demand. Higher yields raise refinancing costs, which worsens the debt path. This is the sovereign-debt feedback loop. In the sovereign-bank nexus, banks hold large amounts of government bonds. Falling bond prices hurt bank capital. Weak banks may need state support, which worsens fiscal strength.

Causes of sovereign crises include large deficits, high short-term or foreign-currency debt, weak growth, contingent liabilities from the banking sector, and sudden loss of investor confidence. A country that borrows in its own currency can usually avoid forced default but may face inflation or currency weakness. A country borrowing in foreign currency has no such option.

Key formulas to remember

Primary balance: Primary balance = Revenue − Non-interest spending; Overall balance = Primary balance − Interest payments.
Debt dynamics (approximate): Δ(d) ≈ [(r − g) ÷ (1 + g)] × d(prev) − pb; d is debt-to-GDP, pb is primary balance as a share of GDP (surplus positive), r is the nominal interest rate on debt, g is nominal GDP growth.
Debt-stabilising primary balance: pb* ≈ [(r − g) ÷ (1 + g)] × d; Primary surplus needed to hold the debt ratio constant. If r < g, it is negative, so a small primary deficit is consistent with a stable ratio.
Debt-to-GDP ratio: d = Public debt ÷ Nominal GDP; Use nominal GDP with nominal rates, or real GDP with real rates. Do not mix them.
Yield on a risky sovereign bond (approximate): Yield ≈ Risk-free yield + Credit spread; Spread ≈ PD × LGD as a rough guide for the default component, plus risk premia.

How to solve Fiscal Policy, Public Debt and Sovereign Risk questions

Use this method for numerical and conceptual questions on fiscal policy, debt and sovereign risk.

1Identify what is asked: a balance, a debt ratio, a stabilising surplus, or a market or policy effect.
2Separate primary balance from overall balance. Check whether interest is included in the figure given.
3Check that r and g are both nominal or both real, and that they are in the same currency terms.
4Compute the r − g gap. Its sign tells you whether debt snowballs or erodes.
5Apply the debt-dynamics or stabilising-balance formula using the debt ratio at the start of the period.
6Link the result to markets: a rising debt path raises perceived default risk, which raises yields and spreads.
7Check for amplifiers: foreign-currency debt, short maturities, bank holdings of sovereign bonds, contingent liabilities.
8State the interpretation in one sentence, not just the number.

Quickest way: r − g shortcut

When to use it: Use for any question asking whether debt is rising, falling or stable, or what primary balance is needed.

Compute (r − g) ÷ (1 + g).
Multiply by the starting debt ratio to get the stabilising primary surplus.
If actual primary surplus is lower, debt ratio rises. If higher, it falls.
For conceptual options, pick the answer that links higher debt or weak growth to higher yields and feedback to funding costs.

Common mistakes in Fiscal Policy, Public Debt and Sovereign Risk

Confusing primary balance with overall balance.
Both are called deficits or surpluses in news and in question stems.
Fix: Ask whether interest is included. Primary excludes interest. Overall includes it.
Assuming a deficit always means debt-to-GDP rises.
Students look at the debt level, not the ratio.
Fix: Debt can grow while the ratio falls if nominal GDP grows faster. Always check g.
Mixing real and nominal rates and growth.
Questions give inflation separately and students use partial figures.
Fix: Use nominal r with nominal g, or real r with real g.
Treating fiscal and monetary policy as the same thing.
Both influence demand and interest rates.
Fix: Fiscal means government spending and tax. Monetary means central bank rates and balance sheet.
Saying a sovereign in its own currency cannot face risk.
Students over-learn that it can print money.
Fix: It avoids forced default in that currency but can face inflation, currency depreciation and loss of investor confidence.
Ignoring the sovereign-bank nexus.
Students treat sovereign and bank risk as separate topics.
Fix: Remember banks hold sovereign bonds and governments back banks. Stress passes both ways.

Worked examples

Example 1

A country has debt-to-GDP of 80%, an average nominal interest rate on debt of 5% and nominal GDP growth of 3%. Using the approximate formula, what primary surplus (as % of GDP) stabilises the debt ratio?

Show the solution

pb* ≈ [(r − g) ÷ (1 + g)] × d.
r − g = 5% − 3% = 2% = 0.02.
Divide by (1 + g) = 1.03: 0.02 ÷ 1.03 = 0.019417.
Multiply by d = 0.80: 0.019417 × 0.80 = 0.015534.
That is about 1.55% of GDP.

Answer: A primary surplus of about 1.55% of GDP.

Example 2

A government with debt-to-GDP of 100%, r = 4% and g = 4% has a primary deficit of 2% of GDP. Over one year, what happens to the debt ratio, and what does this mean for sovereign risk?

Show the solution

Debt change ≈ [(r − g) ÷ (1 + g)] × d − pb.
r − g = 0, so the first term is 0.
pb = −2% (a deficit), so − pb = +2%.
Change in debt ratio = 0 + 2% = +2 percentage points. The ratio rises to about 102%.
Interpretation: with r equal to g, any primary deficit raises the ratio. If this continues, investors may demand a higher risk premium, which raises r and worsens the path.

Answer: The debt ratio rises by about 2 percentage points to roughly 102%. Persistent deficits like this can widen spreads and start a feedback loop.

Exam tips

Most questions are applied: read for whether the data are nominal or real and primary or overall.
Always compute r − g first. It usually decides the direction of debt.
For transmission questions, choose answers that show a feedback loop: higher yields, higher interest cost, weaker debt path.
Link to the 2026 Current Issues reading on rising government debt (BIS Annual Economic Report, monetary and fiscal policy): expect questions on fiscal-monetary interaction and market confidence.
Watch for foreign-currency debt and short maturities as amplifiers of crisis risk.

Practice questions from Monetary and Fiscal Policy: Safeguarding Stability and Trust

Fiscal Policy, Public Debt and Sovereign Risk in other exams

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

Fiscal Policy, Public Debt and Sovereign Risk: frequently asked questions

How does a government deficit affect bond yields?

Larger deficits mean more bond issuance and may raise concerns about debt sustainability. Investors then ask for higher yields to cover default, inflation and supply risk. The effect depends on growth, credibility and who buys the debt.

What is the difference between fiscal policy and monetary policy?

Fiscal policy is government spending and taxation, decided by the government. Monetary policy is the central bank's control of interest rates and liquidity. They interact, and heavy public debt can limit the central bank's freedom.

What causes a sovereign debt crisis?

Common causes are high debt with weak growth, large deficits, heavy short-term or foreign-currency borrowing, and banking-sector liabilities that fall on the state. A loss of investor confidence then raises yields and can make refinancing difficult.

What is debt sustainability?

It means the government can keep servicing its debt without a disorderly adjustment or default. In practice it is assessed through the debt-to-GDP path, which depends on r, g and the primary balance.