Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Exercise 1. Consider an small open economy with 2 periods and one non-storable good. Households receive endowments 1'3,Y2 in periods 1 and 2, respectively, and

image text in transcribedimage text in transcribed

image text in transcribedimage text in transcribed
Exercise 1. Consider an small open economy with 2 periods and one non-storable good. Households receive endowments 1'3,Y2 in periods 1 and 2, respectively, and are taxed l[lump sum) by the government. Let T1, T2 be the lump sum taxes paid by households in periods 1 and 2, respectively. Households cannot borrowr or save. Governments can access credit markets and can decide in t = 2 to repay or default (entirely)I on its debt. Let D1 be the face value of a zerocoupon bond issued by the government in t = 1, to be paid in t = 2, and q1 be the price of the bond. International credit markets are populated by riskneutral foreign investors that can acmss borrowingf lending at the international interest rate 1". The government is benevolent and chooses debt repayment to maximize consumption in t = 2 for the households. If the government defaults, households loose a fraction I of their endowment in period 2. From the perspective of period 1, output in t = 2 is a random variable Y2 uniformly distributed over [0, 2]. A random variable Y is uniformly distributed over [eat] if and only if Pr' gm: 2\" for'yE [55,5]. (a) Write down the budget constraints for the households and the government in t = 1. {b} 1|Write down the budget constraints for the households and the government in t = 2 if the government decides to repay. Write down the budget constraints for the households and the government in t = 2 if the government decides to default. Suppose the equilibrium level of debt in t = 1 is given by D1 = l. {c} Compute the probability of default and the price of debt in t = 1, ql and the value of debt in t = 1, qlDl. Now suppose that in t = 1, after debt is chosen everybody nds out that Y2 is uniformly distributed over [I], 1] {d} Compute the newr probability of default and the prioe of debt in t = 1, .11 and the value of debt in t = 1, 91191. {e} Compute the optimal debt haircut [Lei percent reduction in face value} that maxi- mizes the value of debt qDlD for foreign investors. Now suppose that the original level of debt D1 was held equallyr by N investors, i.e. each of the investors holds debt worth %'- in face value. Suppose a debt haircut as calculated in (e) is proposed to ever],r individual investor. {f} Compute the value of debt for an individual investor that decides to participate in the haircut if all remaining investors also decide to participate. Compute the value of debt for the same investor if he decides not to participate in the haircut when all others decide to participate For which N will an individual investor prefer to participate in the haircut if all other investors are participating

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image_2

Step: 3

blur-text-image_3

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Data Analytics For Accounting

Authors: Vernon Richardson

2nd Edition

1260904334, 9781260904338

More Books

Students also viewed these Economics questions

Question

Statistical regression: Were extreme groups used?

Answered: 1 week ago