Question

1. (a) Existing government debt will generate more government’s liability (=interest payments), and this will increase government debt and budget.

(b) When the government borrows more money (=issuing bonds), the private sector of the economy will reduce investments so that income in the future can be lower than expected.

This is called crowing out effect.

(c) Foreign investors also buy U.S. government bonds, this means we owe to foreigners. Then the U.S. economy can lose some of its controls to foreign investors (not now yet). Foreign countries own about 27% of the U.S. debt at the end of 2018, China currently owns largest part of the foreign portion. China (1.18 tril.), Japan (1.03 tril.) are largest among foreign investors.

      2. (a) FV = 7,000*(1+0.05)^6 = 7,000*1.3409 = $9,386

           (b) PV = 10,000/(1+0.06)^5 = 10,000/1.3382 = $7,473

           (c) Firms’ performances in making profits can decrease if interest rates go up. High interest rates increase cost of production and activities. Their stock prices can go down. Bonds can pay more interests when interest rates go up. So, investors will buy more bonds.     

Answer 1

1. (a) It is true that existing government debt generates more debt due to interest payments and increase the budget. However, the economists are more concerned about debt to GDP ratio. Debt to GDP may stay constant if the nominal GDP country has grown at a rate that cancels the effect of interest payments. Also, the size of the budget may increase or decrease depending upon the government expenditure in the future. The empirical evidence, however, suggests that increased budget-GDP ratio is very difficult to bring down.

(b) It is true if the economy is in full employment.

(c) It is not true. USA has a strong economy with good credibility in the debt market. Therefore, the big foreign investors’ attempt to shift their debt or any attempt to use it as leverage is likely to affect them much more than USA. However, the risky investments by these investors may pose a problem during a negative shock or crisis.