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 rises to $110 billion next year. What will be the value of its consumption if it defaults on the loan?

Question

Quizplus · Accepted Answer

If the country defaults, it faces costs of 25% of its GDP. With a GDP of $110 billion next year, 25% of this is $27.5 billion. Subtracting this from the GDP gives $110 billion - $27.5 billion = $82.5 billion in consumption.

An Emerging Economy as a Current GDP of $100 Billion