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Bond Valuation and Fiscal Policy

1. List and describe the two types of countercyclical fiscal policy.

2. a. What are the advantages of the Fed increasing interest rates when the GDP gap is positive?
b. What are the disadvantages of the Fed increasing interest rates when it believes the GDP gap is positive?

3. Explain what happens to the price of a bond that pays a fixed percent of the face value every year when interest rates in the economy increase.

4. Suppose that a stock has a price that gives it the same expected rate of return as a bank account. Explain why this is not an equilibrium situation.

Solution Preview

1. List and describe the two types of countercyclical fiscal policy.
One is a countercyclical policy in which a tax is reduced to counter global increase in prices of essential goods. For instance, the government reduces taxes on petroleum products when the international prices of oil increase.
Another is to increase the government domestic spending when there is recession in the global economy so that the deleterious effect of global recession does not affect the domestic business and industry. For instance, the government increases its expenditure on infrastructure development when there is global depression.

2. a. What are the advantages of the Fed increasing interest rates when the GDP gap is positive?
When Fed increases the ...

Solution Summary

This solution explains in detail the types of countercyclical fiscal policies, equilibrium situations and GDP gaps.

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