Question

Suppose interest parity does not hold exactly, but the true relationship is R = R∗ + (Ee − E)/E + ρ(B), where ρ(B) is a risk premium on domestic government bonds that positively depends on B. Suppose a temporary rise in domestic government spending is financed by issuing additional government debt (an increase in B) and makes do- mestic public bonds risk premium higher. Evaluate the policy’s output effects in this situation.

Answer 1

It is expressed in the question that the domestic interest rate equals the foreign

interest rate plus expected rate of exchange

rate plus a risk premium.

Now, a permanent fiscal expansionary policy not only appreciates the expected future exchange rate but also increases the risk premium that is it is risky to hold domestic currency deposits.

As a result, the asset market responds to

these changes in two different manners. In

response to a change in expected future exchange rate, the assert market schedule shifts downwards (from AA to AA1) while it

shifts upwards to the right (from AA to AA2)

for an increase in the risk premium.

A permanent expansionary fiscal policy also affects the output market schedule by increasing the aggregate demand; shifting the DD schedule downwards to DD, as shown in

the following diagram:

If there is no risk premium, a permanent fiscal expansionary policy will cause the economy to hold the initial full employment output level of Y; that is economy will from point 0 to point

1, which is corresponding, to Y.

However, with respect to the expression given in the question, an increase in the risk

premium raise the domestic nominal interest

rate causing the output level to be higher than

the initial full employment level of output.

Therefore, the economy moves to point 3

where the output level is higher than Y.