An emerging economy as a current GDP of $100 billion. It borrows $20 billion at a real interest rate of 5%, which it will repay next year. The costs of default are 25% of GDP. Suppose that the country's GDP falls to $80 billion next year. Which of the following is a correct assumption?

Question

Quizplus · Accepted Answer

If the country repays the loan, it will still have a GDP of only $80 billion, but will have to pay back the loan with interest using its reduced income, making it difficult to pay for other necessary expenses. On the other hand, if the country defaults, it will face costs of $20 billion x 25% = $5 billion, which is a lower cost than repaying the loan. Therefore, the country will most likely default on the loan.

An Emerging Economy as a Current GDP of $100 Billion