Suppose that the country of Aquilonia has an inflation rate of about 2 percent per year and a real growth rate of about 3 percent per year.Suppose also that it has nominal GDP of about 400 billion units of currency and current nominal national debt of 200 billion units of domestic currency.Which of the following government spending and taxation figures will keep the debt to-income ratio constant?

Question

Quizplus · Accepted Answer

In order to keep the debt-to-income ratio constant, the nominal national debt should not increase faster than nominal GDP. If inflation is 2% and real growth is 3%, nominal GDP will grow at a rate of 5%. Therefore, if the government spends 30 billion units and collects 20 billion units in taxes, it will have a deficit of 10 billion units each year. However, because nominal GDP is growing by 5%, the ratio of debt-to-income will remain constant at 0.5 (200 billion / 400 billion). If the government spends more or collects less in taxes, the deficit will increase, causing the debt-to-income ratio to rise.

Suppose That the Country of Aquilonia Has an Inflation Rate