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

A sovereign has public debt of 80% of GDP, an average effective interest rate of 4%, and nominal GDP growth of 3%. Ignoring any primary balance, which statement best describes the debt-to-GDP ratio dynamics?

The debt ratio rises, because the 4% interest rate exceeds 3% nominal growth. With no primary balance, debt grows faster than GDP, so the sovereign needs a primary surplus of about 0.8% of GDP to stabilise the ratio.

  1. AThe ratio falls automatically because debt is below 100% of GDP
  2. BThe ratio rises because the interest rate exceeds nominal growth, so a primary surplus is needed to stabilise itCorrect
  3. CThe ratio is unaffected because only the primary balance matters
  4. DThe ratio rises only if inflation exceeds the interest rate

Explanation

Debt dynamics depend on the gap between the effective interest rate (r) and nominal growth (g). Here r-g = 1%, so with a zero primary balance the ratio rises by about 0.8% of GDP per year (0.01 x 80%). A primary surplus of roughly 0.8% of GDP would stabilise it. The level of debt alone does not guarantee a decline.

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