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

A government has debt of 100% of GDP, all financed at an average interest rate of 4%. Nominal GDP growth is 3%, and the primary balance is zero. Holding everything else constant, which is closest to the change in the debt-to-GDP ratio over one year?

The debt ratio rises by about 0.97 percentage points. With a zero primary balance, the change equals (r minus g) divided by (1 plus g) times the debt ratio, which is 1% divided by 1.03 times 100. Interest exceeds growth, so debt rises.

  1. AIncrease of about 0.97 percentage pointsCorrect
  2. BDecrease of about 0.97 percentage points
  3. CIncrease of about 4.00 percentage points
  4. DNo change

Explanation

Change in debt ratio = (r - g)/(1+g) x d minus primary balance = (0.04 - 0.03)/1.03 x 100 = 0.97 points. Option 4.00 ignores GDP growth, and the decrease has the wrong sign because r exceeds g.

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