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

A government's debt is 100% of GDP and the average interest rate on it is 3%. The central bank raises rates so that the average rate on the debt gradually rises to 5%, with no change in debt or GDP. Holding all else constant, by how much does annual interest expense rise as a share of GDP once fully repriced?

Interest expense rises by 2 percentage points of GDP. With debt at 100% of GDP, interest cost equals the average rate, so moving from 3% to 5% lifts the burden from 3% to 5% of GDP. This illustrates how rate hikes strain fiscal positions when debt is high.

  1. A2 percentage points of GDPCorrect
  2. B5 percentage points of GDP
  3. C3 percentage points of GDP
  4. D0.2 percentage points of GDP

Explanation

Interest cost/GDP = debt ratio x rate. Before: 1.00 x 3% = 3%. After: 1.00 x 5% = 5%. The increase is 2 percentage points. Using 3 or 5 ignores that only the change matters.

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