Economics 1420  American Economic Policy

Section Handout – Week 3 September 23-25

Professors Liebman and Summers

Question 1:
According to the Congressional Budget Office, Debt/GDP is projected to equal 98% by the end of 2020. 1
Assume that the nominal interest rate is 2% and that the ratio of the primary deficit to GDP is 1% in
perpetuity. As a reminder, Debt/GDP evolves according to the following formula:

Bt ( 1+ i ) Bt−1 + PD t
=
GDPt ( 1+ g ) GDP t−1

Bt
Where is the Debt/GDP ratio in year t , i is the nominal interest rate, PD t is the primary deficit in
GDPt
year t , and g is the annual nominal GDP growth rate.

In this question, you will examine what happens to the Debt/GDP ratio over time under different
scenarios. We suggest that you use a spreadsheet to answer the following questions and encourage
breakout groups to collaborate via a Google Sheet.
a. Assume that g=4 % . Describe what happens to the Debt/GDP ratio over the next 50 years.
(Hint: To answer this question, we suggest that you setup a spreadsheet as follows: in cell B1,
input the value of g; in cell B2, input the value of i ; in cell B3, input the value for the ratio of the
primary deficit to GDP; and in cells A5 through A55, input the values from 0 to 50. In cell B5,
input the current Debt/GDP ratio and use the formula given above to calculate the Debt/GDP
ratio for years 1 through 50)

b. Explain how it is possible to observe the trend in the Debt/GDP ratio over the next 50 years that
you found in question (a) while still running a positive primary deficit?
Because GDP is going up while interest rates are remaining constant.

c. Assume that g=1% . Describe what happens to the Debt/GDP ratio over the next 50 years.
(Hint: follow the same steps as in part (a), with the parameters and Debt/GDP now in column C.)

Debt GDP goes up significantly.

d. Assume that g=8 %. Describe what happens to the Debt/GDP ratio over the next 50 years.
Debt/GDP goes down to 0.24.

e. Why do the long-run trends in the Debt/GDP ratio in questions (a), (c), and (d) differ?
Because GDP is growing at a different rate.

1
See https://www.cbo.gov/publication/56598.
Question 2 – 2013 Midterm, Part II
a. Suppose the debt-to-GDP ratio is constant at 50%. If the economy grows at 4% per year, how
large is the deficit as a percent of GDP? (primary?)

b. Adding to the set-up, the interest rate on the debt is 2%. How large is the primary deficit as a
percent of GDP?
Question 3 – 2015 Midterm, Part II
(OPTIONAL: please review this problem in your breakout group if time allows or on your own)

Consider the following additional budget and economic statistics:

Government Taxes 15% of GDP

Government Non-interest Spending 20% of GDP
Government Debt 100% of GDP
Nominal Interest Rate 4%
Nominal GDP Growth 6%
Inflation 2%

Using these statistics, please answer the following questions:

a. What are the sizes of this country’s primary and total budget deficits as shares of GDP? Show
how you derive these variables.
The government is concerned about the size of the deficit. It decides to raise taxes from 15% to 20% of
GDP in 2013 and to keep them at 20% of GDP indefinitely. Assume that non-interest spending (as a
share of GDP), the interest rate, and GDP growth remain at their 2012 levels for the foreseeable future.
b. Will the primary and total budget be in surplus, balance, or deficit in 2013 and subsequent
years? Will government Debt/GDP grow or shrink in 2013 and over time?