Reference no: EM131326469

1) You are the economic advisor to Sir Bufton Tufton, the Prime Minister of Per- fidia. The Bank of Perfidia is pegging the exchange rate of the local currency, the Perfidian albion. The albion is pegged to the wotan, which is the currency of the neighboring country of Wagneria.

Until this week both countries have been at full employment. This morning, new data showed that Perfidia was in a mild recession, 1% below desired out- put. Tufton believes a downturn of 1% or less is economically and politically acceptable but a larger downturn is not. He must face the press in 15 minutes and is considering making one of three statements:

1. "We will abandon the peg to the wotan immediately."

2. "Our policies will not change unless economic conditions deteriorate fur- ther."

3. "We shall never surrender our peg to the wotan."

You are Tufton's economy minister. He asks you to give him the pros and cons of each statement. What do you say? (You're not being asked for a recommendation. Rather, you're being asked to brief him on the circumstances in which he's want to give each statement-i.e., you're being asked to educate him so he can choose appropriately.)

4 Default Risk Premia

The country of Delinquia has a non-disaster output level of $100 each year. With 10% probability each year, output falls to a disaster level of $80, and the country will feel so much pain that it will default and pay neither principal nor interest on its debts. The country decides to borrow $20 at the start of the year, and keep the money under the mattress. It will default and keep the money in the event that output is low, but this will entail absorbing $4 in punishment costs. Otherwise it pays back principal and interest due. Lenders are competitive and understand these risks fully.

a. The interest rate on safe loans in world financial markets is 0.08 or 8% per annum (a safe loan pays off 1.08 times $20). What is the lending rate charged by competitive lenders on the risky loan to Delinquia?

b. What does Delinquia consume in disaster years? In non-disaster years?

c. Repeat part b for the case in which Delinquia cannot borrow. Is Delinquia better off with or without borrowing?