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

A country's debt is 90% of GDP with an average interest rate of 3% and nominal growth of 4%, with a primary deficit of 1% of GDP. Use the approximation change in debt ratio = (r - g) × d - primary balance, where primary deficit is a negative balance. Then a shock raises the average interest rate to 5% (growth and primary balance unchanged). By how many percentage points does the annual change in the debt ratio move because of the shock?

The shock raises the annual change in the debt ratio by 1.8 percentage points. The interest-growth gap moves from minus 1 to plus 1 point, which on a 90% debt ratio shifts the effect by 1.8 points, taking the annual change from +0.1 to +1.9 points.

  1. ARises by 1.8 points, from -0.1 to +1.7 pointsCorrect
  2. BRises by 0.9 points, from -0.1 to +0.8 points
  3. CRises by 1.8 points, from +0.1 to +1.9 points
  4. DRises by 2.0 points, from -1.0 to +1.0 points

Explanation

Before: (3-4)% × 90% = -0.9; minus primary balance (-1) gives -0.9 + 1 = +0.1. After: (5-4)% × 90% = +0.9, plus 1 = +1.9. The change is +1.8 points, from +0.1 to +1.9. Option 1 mislabels the starting level, so the correct pairing is +0.1 to +1.9.

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