Question

In \(2014,\) the policy makers of the economy of Eastlandia projected the debt- GDP ratio and the ratio of the budget deficit to GDP for the economy for the next 10 years under different scenarios for growth in the government's deficit. Real GDP is currently \(\$ 1,000\) billion per year and is expected to grow by \(3 \%\) per year, the public debt is \(\$ 300\) billion at the beginning of the year, and the deficit is \(\$ 30\) billion in 2014 . a. Complete the accompanying table to show the debt-GDP ratio and the ratio of the budget deficit to GDP for the economy if the government's budget deficit remains constant at \(\$ 30\) billion over the next 10 years. (Remember that the government's debt will grow by the previous year's deficit.) b. Redo the table to show the debt-GDP ratio and the ratio of the budget deficit to GDP for the economy if the government's budget deficit grows by \(3 \%\) per year over the next 10 years. c. Redo the table again to show the debt-GDP ratio and the ratio of the budget deficit to GDP for the economy if the government's budget deficit grows by \(20 \%\) per year over the next 10 years. d. What happens to the debt-GDP ratio and the ratio of the budget deficit to GDP for the economy over time under the three different scenarios?

Short answer

Under scenario A, the debt-GDP ratio and the deficit-GDP ratio both decrease over time since the deficit is constant and GDP is growing. However, under scenarios B and C, the ratios will initially decrease but will eventually increase as the compounding effect of the growing deficit outpaces the GDP growth.

Step-by-step solution

Find the GDP for Each Year

Assuming that the GDP grows at a constant rate of 3% per year, we calculate the GDP for each successive year using the formula: Future GDP = Current GDP × (1 + growth rate)^number of years. Use this formula to calculate GDP for each year from 2014 to 2023.

Calculate Debt for Scenario A

For scenario A, where the government's budget deficit remains constant at \(30 billion, calculate the new debt for each year by adding the previous year's deficit. The debt at the end of each year is equal to the previous year's debt plus the deficit of \)30 billion.

Calculate Debt-GDP Ratio and Deficit-GDP Ratio for Scenario A

For each year, calculate the debt-GDP ratio by dividing the debt by that year's GDP. Calculate the budget deficit to GDP ratio by dividing the constant deficit of $30 billion by the GDP of that year.

Calculate Debt for Scenarios B and C

For scenarios B and C, where the government's budget deficit grows by 3% and 20% per year respectively, calculate the new deficit for each year first, then calculate the new debt by adding the new deficit to the previous year's debt.

Calculate Debt-GDP Ratio and Deficit-GDP Ratio for Scenarios B and C

With the new deficits and debt figures, calculate the debt-GDP and deficit-GDP ratios for each year as in Step 3.

Analyze Trends Over Time

Compare the debt-GDP and deficit-GDP ratios calculated for each scenario across the years to determine how they change over time under the different deficit growth scenarios.

Key concepts

Budget Deficit

Understanding the budget deficit is crucial for evaluating a country's economic health. Essentially, a budget deficit occurs when a government spends more money than it receives in revenue within a given period, typically a fiscal year.

When a government experiences a deficit, it must borrow money to finance the gap between its expenditures and revenue. This borrowing increases the country's government debt. Policymakers analyze the deficit as a percentage of GDP (Gross Domestic Product) as it allows for comparison across economies or within the same economy over time.

A consistent budget deficit can lead to a growing debt burden, raising concerns about a country's fiscal sustainability. Yet, in certain circumstances, running a deficit can be a strategic aspect of fiscal policy, especially during economic downturns or to finance investments aiming to stimulate economic growth.

Real GDP Growth

Real GDP growth measures the increase in the value of all goods and services produced by an economy over time, adjusted for inflation. This means it reflects the 'real' quantity of goods and services produced, rather than changes in price levels.

Positive real GDP growth indicates a growing economy, which can lead to improved living standards and decreased unemployment rates. Conversely, if GDP growth is slow or negative, it can signal economic stagnation or recession.

The rate of real GDP growth is a critical factor in the debt-GDP ratio computation. If the GDP grows at a slower rate than the government's debt, the debt-GDP ratio will rise, indicating a heavier debt burden in relation to the economy's size.

Fiscal Policy

Fiscal policy involves government strategies to influence macroeconomic conditions through spending and taxation. For instance, during recessions, governments may increase spending (expansionary fiscal policy) to boost demand and reduce unemployment.

Conversely, to cool down an overheating economy and control inflation, a government might reduce spending or increase taxes (contractionary fiscal policy). The balance between these decisions can affect the budget deficit and, by extension, real GDP growth and government debt.

A well-calibrated fiscal policy can support sustainable economic growth and maintain a manageable debt-GDP ratio. Poorly managed fiscal policies, however, can lead to excessive debt accumulation and economic instability.

Government Debt

Government debt is the total amount of money owed by the government to creditors. It accumulates over time as governments finance budget deficits by borrowing.

To evaluate the significance of government debt, we can compare it to the country's GDP. This debt-GDP ratio gives a sense of the country's debt in relation to its economic production capacity.

If the debt-GDP ratio is high, it can indicate that a country might struggle to repay its debts without compromising economic growth. Creditors may see such a country as a higher risk, leading to increased borrowing costs. Keeping the debt-GDP ratio at a sustainable level is a sign of good fiscal health and is often a target of economic policy.