4. Consider an economy with a strictly positive debt-to-GDP ratio and a primary balance relative to GDP which keeps the debt-to-GDP ratio constant over time. Assume that in so- me period T, the government loosens fiscal policy so that the primary balance decreases for one period and then increases back to its initial level. As a result, the debt-to-GDP ratio increases at least initially. In the next period (period T+1), the primary balance relative to GDP increases back to its initial level (which kept the previous debt-to-GDP ratio constant over time). Real GDP grows at a constant rate g and the real interest rate on government is fixed at r. i) Set the initial debt-to-GDP ratio equal to 100%, r = 2%, g = 3% and assume that the primary balance decreases by 1 percentage point in period T relative to the level which keeps the debt-to-GDP ratio constant over time. Compute how the debt-to-GDP ratio evolves over the next 20 periods and show the results (debt-to-GDP ratio from period T to period T+20)
4. Consider an economy with a strictly positive debt-to-GDP ratio and a primary balance relative to GDP which keeps the debt-to-GDP ratio constant over time. Assume that in so- me period T, the government loosens fiscal policy so that the primary balance decreases for one period and then increases back to its initial level. As a result, the debt-to-GDP ratio increases at least initially. In the next period (period T+1), the primary balance relative to GDP increases back to its initial level (which kept the previous debt-to-GDP ratio constant over time). Real GDP grows at a constant rate g and the real interest rate on government is fixed at r. i) Set the initial debt-to-GDP ratio equal to 100%, r = 2%, g = 3% and assume that the primary balance decreases by 1 percentage point in period T relative to the level which keeps the debt-to-GDP ratio constant over time. Compute how the debt-to-GDP ratio evolves over the next 20 periods and show the results (debt-to-GDP ratio from period T to period T+20)
Chapter1: Making Economics Decisions
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Transcribed Image Text:4. Consider an economy with a strictly positive debt-to-GDP ratio and a primary balance
relative to GDP which keeps the debt-to-GDP ratio constant over time. Assume that in so-
me period T, the government loosens fiscal policy so that the primary balance decreases for
one period and then increases back to its initial level. As a result, the debt-to-GDP ratio
increases at least initially. In the next period (period T+1), the primary balance relative to
GDP increases back to its initial level (which kept the previous debt-to-GDP ratio constant
over time). Real GDP grows at a constant rate g and the real interest rate on government is
fixed at r.
2%, g
=
i) Set the initial debt-to-GDP ratio equal to 100%, r =
: 3% and assume that the
primary balance decreases by 1 percentage point in period T relative to the level which keeps
the debt-to-GDP ratio constant over time. Compute how the debt-to-GDP ratio evolves over
the next 20 periods and show the results (debt-to-GDP ratio from period T to period T+20)
with a graph.
ii) Assume now that r = 3% and
why the results look different.
g
=
2
2% and repeat the exercise in part i). Explain briefly
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