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

A country's sovereign has debt of 100% of GDP, all refinanced at an average interest rate that moves one-for-one with the policy rate. The policy rate rises from 2% to 6%, and the entire debt stock is assumed to reprice immediately. Nominal GDP growth is 4%, and the primary balance is zero. Holding other things fixed, what is the approximate change in the debt-to-GDP ratio over one year, relative to the starting level of 100%?

The debt ratio rises to about 102% of GDP. With a zero primary balance, the change equals (interest rate minus nominal growth) times the debt ratio, which is (6% - 4%) x 100% = 2 percentage points, so the ratio increases from 100% to 102%.

  1. ARises to about 102%, since (6% - 4%) x 100% = 2 percentage pointsCorrect
  2. BFalls to about 98%, since growth exceeds the old rate
  3. CRises to about 104%, since interest is 6% and growth is ignored
  4. DStays at 100%, since the primary balance is zero

Explanation

Debt dynamics with a zero primary balance: change in ratio ≈ (r - g) x debt ratio = (6% - 4%) x 100% = 2 points, giving 102%. The option ignoring growth gives 106%-style reasoning (104% mismatches both), and zero primary balance does not stabilize the ratio when r exceeds g.

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