Question

You are appointed secretary of the treasury of a recently independent country called Rugaria. The currency of Rugaria is the lav. The new nation began fiscal operations this year and the budget situation is that the government will spend 10 million lavs and taxes will be 9 million lavs. The 1-million-lav difference will be borrowed from the public by selling 10 year government bonds paying 5 percent interest. The interest on the outstanding bonds must be added to spending each year, and we assume that additional taxes are raised to cover that interest. Assuming that the budget stays the same except for the interest on the debt for 10 years, what will be the accumulated debt? What will size of the budget be after 10 years?

Answer 1

Answer:

A) The accumulated debt will be = lav 1 million

B) The size of the budget be after 10years = lav 10.63million

Explanation:

The government will spend 10 million lav and tax collection will be 9 million lav in the new nation budget situation.

accumulated debt is the deficit in the budget.

Budget deficit = Government Spending  - Taxes

                       = lav 10,000,000 - lav 9,000,000

                       = lav 1,000,000

Government plans to borrow 1,000,000 by issuing 10yrs bond with 5% interest. The 5% Interest will be part of government spending each year.

Interest amount to be paid ===>  (5/100)*1,000,000 = 0.05 milion lav

Future Value = PV* $( 1 + interest )^{years}$

                     = $1 (1 + 0.05)^{10}$

                     = 1.63 million

∵ after 10yrs, 1 million bonds will become 1.63 million and interest is collected in form of taxes. additional tax:

Additional Tax = 1.63 - 1.00

                        = 0.63 million (paid to tax holder).

Calculate the total budget size:

Total Budget Size = 10 + 0.63

                              = 10.63 million