In the old days when I worked for the government my annual raises were divided into two parts:
- an increment for performance and time in service, and
- an increment to reflect the general inflation.
Assume that the first increment was 5 percent and the second was 3 percent, then the total increase in pay would be 8 percent.
Debt normally is not indexed for inflation. Annual interest payments are calculated to reimburse the lender for the loss of principle due to inflation and the delay in gratification from the use of the money for his/her own purposes. Thus if one pays the interest as it is due, the increase in the debt per year is just the new borrowing. Thus in the example above, one could borrow up to 8 per cent of the current debt during the year without increasing debt as a percent of income.
One might make a similar analysis for net worth. The value of ones net worth can be divided into the component that increases in value with inflation and that which does not. Thus the increase in net worth during a year is the savings (which is invested that year) plus the increase due to inflation of that part which experiences inflation. In the example above, if the total increase in net worth were more than 8 percent of total net worth during a year, the ratio of net worth to income would be increasing.
Of course, as one grows older in one's working career, debt should be decreasing with respect to income while net worth should be increasing with respect to income.
The same kind of analysis can be applied to the fiscal situation of the government. If the GDP is increasing by 2 percent per year in real terms and the inflation is held to 3 percent per year, then the growth of nominal GDP is 5 percent per year. If the government deficit were such as to increase the national debt by 4 percent, that debt would actually be decreasing as a portion of GDP.
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