2) (70 points total) Suppose we have an emerging economy with a current GDP of $100 billion. It borrows $20 billion at a real interest rate of 5%, which it plans to repay next year. The costs of default are 25% of GDP. Consider 2 scenarios: Scenario A: GDP next period is $100 billion Scenario B: GDP next period is $80 billion a) (10 points) Assuming scenario A, is it in the best interest of this emerging economy to pay its debt or default? Show all work and explain.

b) (10 points) Assuming scenario B, is it in the best interest of this emerging economy to pay its debt or default? Show all work and explain.

c) (20 points) Now draw a repayment vs. default diagram with consumption on the vertical axis and GDP on the horizontal axis (as in the textbook and lecture). Assuming scenario A, label this point as point A. Similarly, assuming scenario B, label this as point B. Be sure your diagram is completely labeled with a consumption if you default line, a consumption if you pay line, slopes labeled as well as repayment threshold level of GDP (Y_T) and the default / repayment zones. Please show your work calculating Y_T.

d) (10 points) Suppose we are at the repayment threshold where GDP = Y_T. If the parameter c falls to .20, how would your diagram change and what would happen to the repayment threshold (Y_T) and why? Given the same GDP (i.e., we are holding GDP constant), would it better to pay or to default? Show your work. What is the new repayment threshold Y_T?

e) (10 points) Let's return to the original conditions where c = .25 and we are at the (original) repayment threshold where GDP = Y_T. Suppose this emerging economy elects a new prime minister that has a poor history in terms of corruption and thus the interest rate r_L rises to 10%. How would your diagram change and what would happen to the repayment threshold (Y_T) and why? Given the same GDP (i.e., we are holding GDP constant), would it better to pay or to default? Show your work. What is the new repayment threshold Y_T?

f) (10 points) Let's return to the original conditions where c = .25 and we are at the (original) repayment threshold where GDP = Y_T. Suppose alternatively that this emerging economy elects a new prime minister that has no experience with counter-cyclical policy and thus, the (expected) volatility of output rises. Explain what happens to the repayment threshold Y_T, the repayment region, and the probability of default and why.