2. (20 points) Consider the model of government budget analyzed in class applied to a developing country, e.g., Ar- gentina. Suppose risk-free rate is 0%. The expected GDP is $100 billion per year and the risk premium on a claim to GDP is 5%, ry = 5%. (Note that because the risk-free rate is 0%, the risk premium of assets also equals the required return on assets). The government spendings constitute 20% of GDP and taxes constitute 15% of GDP. The government also uses inflation tax (also known as seigniorage) as well as sovereign debt to balance its budget (see figure below). The value of government debt is $200 billion. Government Budget Inflow Outflow Taxes (T) Gov't Spending (G) Seigniorage (S) Sovereign Debt (D) (a) Suppose that the government adjusts the inflation tax to keep its sovereign debt safe (rd = 0%). Use Modigliani- Miller propositions 1 and 2 to find the present value of seigniorage revenues and the risk premium on a claim to seigniorage revenue, rs. Hint: As a preliminary step, you might need to compute the present value of GDP, government spendings, and tax revenues. (b) Suppose now that the country's central bank becomes independent. As a result, the expected seigniorage revenue becomes $8 billion per year and the risk premium on a claim to seigniorage revenue becomes rs = = 4%. Use Modigliani-Miller model to find the new credit spread on the sovereign debt. 2. (20 points) Consider the model of government budget analyzed in class applied to a developing country, e.g., Ar- gentina. Suppose risk-free rate is 0%. The expected GDP is $100 billion per year and the risk premium on a claim to GDP is 5%, ry = 5%. (Note that because the risk-free rate is 0%, the risk premium of assets also equals the required return on assets). The government spendings constitute 20% of GDP and taxes constitute 15% of GDP. The government also uses inflation tax (also known as seigniorage) as well as sovereign debt to balance its budget (see figure below). The value of government debt is $200 billion. Government Budget Inflow Outflow Taxes (T) Gov't Spending (G) Seigniorage (S) Sovereign Debt (D) (a) Suppose that the government adjusts the inflation tax to keep its sovereign debt safe (rd = 0%). Use Modigliani- Miller propositions 1 and 2 to find the present value of seigniorage revenues and the risk premium on a claim to seigniorage revenue, rs. Hint: As a preliminary step, you might need to compute the present value of GDP, government spendings, and tax revenues. (b) Suppose now that the country's central bank becomes independent. As a result, the expected seigniorage revenue becomes $8 billion per year and the risk premium on a claim to seigniorage revenue becomes rs = = 4%. Use Modigliani-Miller model to find the new credit spread on the sovereign debt