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Unformatted text preview: Economics 314: Suggested Solutions to HW 4 TA: Romita Mukherjee October 16, 2008 1 Problem 1, [Page 5, L4] (1) We know the asset market equilibrium condition is given by: i t = r t- 1 unit of good: renting gives 1 + r t- at the end of t so 1 + r t at the start of t + 1 . 1 unit of good: lending gives 1 + i t at the start of t + 1 . If r t- = 5% and i t = 4%, then under these rates everyone borrows in the bond market and then rent the borrowed good in the rental market, but no one supplies in the bond market. So demand=supply is impossible in the bond market. (2) Similarly, r t- =4% and i t =5%, then everyone lends his good in the bond market to enjoy the better rate of return. So no one rents in the rental market. So no capital input, which means MPK (which is also the rental rate) is infinite. But then r t- is infinite, which is impossible to be less than it . (3) r- is the return for stocks, and i is the return for treasury bonds. In reality these returns are different because, when writing the condition...
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