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 real rate of interest rises from 5% to 7.5%. With the country's GDP level of $110 billion, what will happen to the threshold level of GDP?

Question

Quizplus · Accepted Answer

The threshold level of GDP will rise because the cost of borrowing increases with the higher interest rate, making it more difficult for the country to repay its debt without defaulting. This means the GDP level at which the country can avoid defaulting (the threshold level) must be higher.

An Emerging Economy as a Current GDP of $100 Billion