If the government runs a primary deficit in year zero of B0, and, in year 1, decides to stabilise the debt (i.e., prevent the deficit from rising any further), then in year 1 and beyond, it must run a primary surplus equal to:
A) B0.
B) zero.
C) rB0.
D) B0(1 + r).
E) B0(1 + r)t.

Question

Quizplus · Accepted Answer

In order to stabilize the debt, the government needs to ensure that the primary deficit (B0) is not added to the existing debt. This means that the government needs to balance its budget at least for the primary expenditure (i.e., excluding interest payments) in year 1 and beyond. However, the government still needs to make interest payments on the existing debt, which requires a primary surplus equal to r times the existing debt. Therefore, the government needs to run a primary surplus equal to rB0 to stabilize the debt.

If the Government Runs a Primary Deficit in Year Zero