Suppose that a country has an inflation rate of about 4 percent per year and a real GDP growth rate of about 3 percent per year. What is the highest deficit the government can afford without raising the debt-to-income ratio?
A)about 12 percent of GDP
B)about 7 percent of GDP
C)about 1 percent of GDP
D)0

Question

Quizplus · Accepted Answer

The highest deficit the government can afford without raising the debt-to-income ratio is the difference between the real GDP growth rate (3 percent) and the nominal interest rate on the debt (assuming the government issues debt to finance the deficit) minus the inflation rate. Therefore, the highest deficit is approximately 3 percent - nominal interest rate on debt - 4 percent. If we assume the nominal interest rate on debt is around 6 percent, the highest deficit would be around -7 percent, which means that the government must run a surplus of 7 percent to avoid raising the debt-to-income ratio. Option B is the closest to this calculation.

Suppose That a Country Has an Inflation Rate of About