Question 5 - Fiscal Policy

No more than 500 words

Define the concept of sustainability (debt sustainability) precisely and match it with the relevant data for Italy and Argentina (use the website of the International Monetary Fund)

Answer the following question: Do you think the debt to GDP ratio of Italy and Argentina are sustainable going forward? Explain clearly the criteria you need to use in order to evaluate the sustainability of the debt.

Hint: Consider different scenarios regarding different future real GDP growth rates and average sovereign costs of borrowing. Which one do you think is the most relevant scenario for the two countries and why?

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Concept of long run debt sustainability

Notes...

Every period the government runs an overall deficit, its debut increases: when spending plus interest payments on the existing stock of debt exceeds tax revenues, the stock of debt will rise. But it does not follow from this that government can not afford to run deficits for long periods. So long as the stock of debt does not keep rising relative to GDP, then the government is likely to be able to keep paying interest on its debt. At unchanged interest rates, the burden of paying interest would be constant relative to GDP if the debt to GDP ratio is steady. This is why stability of the ratio of the stock of government debt to GDP considered the best way to judge sustainability of the fiscal position.

Government needs to run a primary surplus to cover the excess of interest payments over GDP growth. Debt is sustainable if debt is not changing

(1) Ratio rises because of interest payments r x (Debt/GDP)

(2) Ratio falls because of output growth g x (Debt/GDP)

(3) Debt increases because of primary deficit Putting (1), (2) and (3) together:

Change Debt/GDP = (r-g) Debt/GDP + Primary Deficit/GDP Debt sustainability (Change Debt/GDP = 0), implies: (r-g) Debt = Primary Surplus