Suppose that a country has an inflation rate of about 4 percent per year and a real GDP growth rate of about 2 percent per year. What is the highest deficit the government can afford without raising the debt-to-income ratio?
A) about 2 percent of GDP
B) about 6 percent of GDP
C) about 8 percent of GDP
D) about 12 percent of GDP

Question

Quizplus · Accepted Answer

The highest deficit a government can afford without raising the debt-to-income ratio is equal to the difference between the real GDP growth rate and the nominal interest rate, multiplied by the existing debt-to-GDP ratio. If we assume that the nominal interest rate is equal to the inflation rate (4 percent) plus a risk premium of 2 percent, then the nominal interest rate is 6 percent. Therefore, the highest deficit the government can afford is 2 percent (calculated as 6 percent - 2 percent) of GDP, which is option B.

Suppose That a Country Has an Inflation Rate of About