Economics 435 Menzie D. Chum Fall 2021 Social Sciences '1-'418 University of Wisconsin-Madison Problem Set 2 Due via Canvas on Friday October 13, 11pm (You can submit early). Be sure to put your name on your problem set. Put \"boxes" around your answers to the algebraic questions. 1. Consider the Aggregate Demand-Aggregate Supply amework, where initially the economy is at short and long run equilibrium. Suppose government spending is reduced. You can assume for simplicity expected ination is always zero. 1.1 Show what happens in an ISLLM and ADAS graph in the period the government spending reduction occurs. LM | MI, PI i IS A Y P ASLR PI ADAI, MI Y1 =Y* Y 1.2 Show what happens over time to output, the price level, and the interest rate. 2LM | MI, P, IS | A Y P ASLR PI AD|AI, MI Y1 =Y* Y 1.3 Repeat 1.1 and 1.2, assuming potential GDP falls by the same amount the AD curve shifts. 32.1 LookuponBloomberg....-. - . the yield on (as close as possible to) a one year T hill. Calculate the price as ifthe hond were to mature one year from now (specify the date you looked up the data) Show your calculations. 2.2 Once again, look up the one year and two year yields. Assuming the expectations hypothesis ofthe term structure holds, what is the expected interest one year interest rate, one year from today. Show your calculations. 2.3 Handdraw the yield curve, for 3 months to 30 years (at 3, 6, 12 months, 2, 5, ll}, 30 years) 2.4 Assuming the expectations hypothesis of the term structure holds [i.e., there is no term premium), do you expect the US economy u. go into recession in the next year? Why or why not? 3. Consider the following picture of corporate bond spreads (as calculated by Gilchrist and ZahajSek}, corrected for maturity differences. Ham\" 0 um m 1.?! m: ms 1' I9! \"I! W m M! an m N12 MI! 3.1 Explain why the spread exhibits the pattern it does, with respect In the business cycle. 3.2 Is the entire movement in the spread due to changes in probability ofdefanlt over time? 4. Asset prices. Suppose: D EIPH'I :1] =+ (2} 1+1f+rp 1+1f+pp r 4.1 Solve for the stock price assuming expectations are rational and there are no bubbles. Show your work as much as possible. 4.2 Calculate the price of a share of stock, assuming dividends are expected to be constant at 09 = 1 and (yf+ pp) is also expected to be constant at 0.10. Show your algebraic work 4.2 (4 minutes) Suppose that you revise your expectations regarding [1f+ no) downward by 4 percentage points. What immediately happens to the price of the share of stock? Once again, show your work. MSpsZ_EI oinmu