Consider a country whose real GDP is currently growing at 6%. Inflation is 2% per year, and nominal interest rates on government debt are 5% per year. The country starts with a debt to GDP ratio of 100%.

Taking under consideration the prospective increase in deficits, the country's key policymakers decide to embark on an immediate plan of fiscal austerity, which cuts back the deficit to its pre-recession value of 1.5%. This program involves large tax increases and reductions in government spending. Assuming real GDP growth stays at 3% and nominal interest rates stay at 8% per year, does this austerity plan make debt burden look sustainable?

What are the advantages and disadvantages of embarking on the austerity plan right now? Recall, the economy is in a recession. In particular, discuss the potential effects of the plan on real GDP growth, nominal interest rates, and other variables. On balance, do you think the government is right to implement the plan right now? Can you describe the merits/demerits of two alternate options: i) delay austerity until after the recession; ii) expand the money supply?