3. Interest on debt Aa Aa Suppose that the debt to GDP ratio in a hypothetical c

Question

3. Interest on debt Aa Aa Suppose that the debt to GDP ratio in a hypothetical country reaches 200%. For many years, investors had been willing to lend to the government at very low interest rates. But now, investors become worried that the government might default on its debt-that is, might refuse to pay the investors back. As a result, the investors are now willing to lend to the government only if they receive a high interest rate of 20%. (Several years before Argentina defaulted on its debt, investors demanded interest rates on its debt of more than 20% per year, so 20% is not an unrealistic number.) Suppose that debt is equal to 180 trillion ducats and GDP is equal to 90 trillion ducats. If interest payments are equal to the interest accrued in a given year, how much would the government's interest payments on its debt be as a percentage of GDP? O 4% 2% 0 1296 o 40% O 20%

Explanation / Answer

Correct option is (4).

Annual interest payment (Trillion ducat) = Debt x Interest rate = 180 x 20% = 36

Interest payment-to-GDP Ratio = Annual interest payment / GDP = 36 trillion ducats / 90 trillion ducats = 0.4 = 40%

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