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

A country's government debt is 90% of GDP. The average interest rate on that debt is 3%, nominal GDP growth is 5%, and the primary balance is zero. Holding these constant, which statement best describes the debt-to-GDP ratio's behavior?

The debt-to-GDP ratio falls. With a zero primary balance, the ratio changes only through the gap between the interest rate and nominal growth. Growth of 5% exceeds the 3% interest rate, so GDP expands faster than debt accumulates, shrinking the ratio by roughly 1.7 points a year.

  1. AIt rises, because interest costs are paid every year
  2. BIt falls, because nominal growth exceeds the interest rateCorrect
  3. CIt stays at 90%, because the primary balance is zero
  4. DIt rises, because a zero primary balance means the budget is in deficit

Explanation

Debt dynamics follow change in ratio ≈ (r − g)/(1+g) × debt − primary balance. Here r − g = −2 percentage points, so with a zero primary balance the ratio falls by roughly 0.02/1.05 × 90% ≈ 1.7 points per year. Option C ignores the interest-growth differential.

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