Assume the government’s budget constraint is: G+iD-tY= D * where: G = government

Question

Assume the government’s budget constraint is: G+iD-tY= D*

where: G = government purchases t = the net tax rate i – the nominal interest rate Y – real GDP D = nominal debt outstanding D*= change is debt.

Currently, the total federal debt approximately equals GDP. The average interest rate on the debt is approximately1.5%. Assuming no other changes, if the average interest on the debt increases to 4.5%, what happens to government spending and the deficit as a percentage of GDP? Is this likely sustainable? Explain.

Explanation / Answer

With increase in the interest rate on debt the government spending will decreases as it will increase the budget deficit more. The deficit as a percentage of GDP will increase as Deficit is directly related to the interest rate on the debt. N this is not sustainable because this depends a lot in the prevailing economic conditions. If gt expenditure is likely to increase the interest on debt will also increase thus raising deficit.

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