When GDP volatility increases, it changes the equilibrium in the credit market for sovereign borrowers. How?
A) Volatility increases the probability that a nation will repay and decreases the need to borrow, so the equilibrium debt level and interest rates drop.
B) Volatility decreases the probability that a nation will repay and increases the need to borrow, so the equilibrium debt level is indeterminate and interest rates rise.
C) Volatility decreases the probability that a nation will repay and decreases the need to borrow, so the amount of debt level will fall and interest rates drop.
D) Volatility increases the probability that a nation will repay and increases the need to borrow, so the amount of debt level and interest rates rise.

Question

Quizplus · Accepted Answer

When GDP volatility increases, it creates uncertainty about a nation's ability to repay its debt, causing lenders to demand higher interest rates to compensate for the increased risk. This increases the cost of borrowing, which in turn increases the need to borrow to cover the interest payments. As a result, the equilibrium debt level becomes indeterminate, as lenders try to balance the risk of default against the need for higher returns.

When GDP Volatility Increases, It Changes the Equilibrium in the Credit