1. Description of the economy Government. The economy lives for two periods: t = 1 and t = 2 (we can interpret t = 1 as being today and t = 2 as being some fairly distant future). In each period, the government must make purchases: G1 = 10 and G2 = 10. At t = 1 the government is able to collect taxes T1 = 5 and can sell bonds (i.e. issue debt) B1 to cover the remaining part of the expenditure. That debt will have to repaid in period t = 2 with interest r. There is a large number of risk-neutral investors that buy the government debt. These investors have access to some risk-free bond (e.g. a German T-bill) that yields a net return r prime.

Q1. Write down the budget constraint the government faces in period 1. Write down the separate budget constraint the government will face in period t = 2. What is the level of borrowing in t = 1 (i.e. what is B1)?

Q2. Suppose the government can commit to repaying the debt in period t = 2. What is the interest rate it will have to pay on the debt issued in t = 1 (explain)?

Q3. At the interest rate you calculated in the previous part, what will be level of taxes at t = 2?

Q4. Suppose that due to a political conflict inside the country, there is a risk the government will default in its debt in t = 2. The investors perceive the probability of that default to be delta= 0:10. What interest will they demand?

Q5. At the interest rate you calculated in the previous part, what will be level of taxes at t = 2, if we assume the government actually does repay the debt? What will be the level of taxes at t = 2, if the government in fact defaults on the debt?

Q6. Does your answer to previous part imply the government should in fact default? Explain.