4. Suppose that the U.S. net foreign debt (liabilities less assets) is equal to

Question

4. Suppose that the U.S. net foreign debt (liabilities less assets) is equal to 25 per cent of the country’s GNP and that foreign assets and liabilities pay an interest rate of 5 per cent per year. (a) What would be the “debt burden” for the U.S. (i.e. interest on debt as a percentage of GNP) from paying interest on the net foreign debt? Do you think this is a “large” number? (b) What is the net foreign debt were 100 per cent of GNP? (c) Using the tools you learned in FIN 402, write out the formula that describes next year’s debt burden, given the interest rate r, the growth rate of the economy g, and the net stock of debt (as percent of GNP) = d. Comment on result.

Explanation / Answer

a) 0.25 * 0.05 = 0.0125

Debt burden is 1.25% of GNP and it is quite small.

b) If the net foreign debt is 100% of GNP then

1.00 * 0.05 = 0.05 or 5%

c) If g = growth rate then

d1= d * (1+(r-g))

If growth rate tends to be more than prevailing interest rate then net debt burden will lower but if growth rate tends to lower then it will raise the burden.

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