Assume That Initially, the Risk Premium, ρ = 0 and That

question 73

Essay

Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e.
ρ = ρ^(B-A)
How much will the central bank have to reduce domestic assets A s.t. the domestic interest rate will increase by (a) 1% (b) 4%?

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Definitions:

Monopolistically Competitive

A market structure featuring many firms selling products that are similar but not identical, allowing for some degree of market power and price setting.

Long Run

A period in economics during which all factors of production and costs are variable, allowing firms to adjust all inputs.

Deli

A short form for delicatessen, which is a store or counter specializing in prepared foods, sandwiches, and specialty groceries.

Zero Economic Profits

A condition in perfect competition where firms earn just enough revenue to cover their total costs, leading to no supernormal profit in the long term.