Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Size of a National Debt Relative to GDP

Size of a National Debt Relative to GDP

The national debt is the total amount of money owed by the central government. It is important for a country to grow its economy and, at the same time, reduce its national debt. Many believe that government debt can cause great political instability. To some degree, this could be true because it may cause:

  • a loss of confidence by investors;
  • reduced government spending; and
  • the printing of currency, leading to inflation.

However, this is usually not the case. High national debt does not necessarily cause instability. In fact, on the contrary, it may even prevent deeper economic depressions. Some economists argue that during a recession, government borrowing and spending can help prevent a collapse in demand and growth.

In a recession, individuals tend to save more and they can therefore buy government debt denominated in their own currency. This allows the government to borrow at low prices to finance public sector expenditures.

National debt matters depending on the following factors:

  1. the way it has been financed. For instance, depending on overseas borrowing can be risky because of currency rate risk;
  2. higher economic growth enables a country to be able to repay its debt. If a country is stuck in a recession, the debt will increase relative to the GDP;
  3. domestic investors are willing to buy government bonds. When a country has a large pool of domestic savings, its government will borrow cheaply; and
  4. there is a structural deficit, and the government is borrowing heavily in a period of growth.

For a stable economy, the government needs a low and stable inflation rate and a sustainable economic debt.

Crowding Out

During recessions, the private sector borrows less but saves more. A more critical situation occurs when both the private sector and government debt grow simultaneously, as this will eventually result in crowding out. Crowding out can lead to a substantial rise in interest rates, which discourages businesses from making capital investments.

Asset Bubbles

A persistent lack of capital caused by consumption demand and speculative asset prices creates bubbles. The most likely outcome will be short-term economic growth and a long-term decline in growth, as seen from the housing bubble that took place before the 2007-2008 housing market collapse and subsequent recession.

Question

Which one of the following is most likely a disadvantage of national debt?

A. A country acquires additional funds for growth

B. National debt improves the standard of living

C. National debt can cause inflation

Solution

The correct answer is C.

When the government borrows too much, it causes problems by raising interests rates and consequently inflation.

Options A and B are potential advantages of national debt.

Reading 16 LOS 16q:

Describe the arguments about whether the size of a national debt relative to GDP matters

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.