The sustainability of fiscal policy is partly a function of the GDP growth rate. In the wake of the earthquake and related tsunami in March 2011, it appears that Japan’s growth rate in the near term may be even lower than the 10-year average of 0.7%.
a. If the growth rate of GDP fell to -0.5%, how would this affect the sustainability of fiscal policy?
b. Based on the growth rate in part (a), calculate the level of the primary deficit required to make fiscal policy sustainable.
c. Historical data suggest that even major catastrophes such as Hurricane Katrina have only a small and short-term effect on economic growth. However, it is certain that the aftermath of the disaster in Japan will require large government expenditure to rebuild infrastructure. How will this affect Japan’s deficit and debt in the short run?