Question

Some questions I need some explanation on, thank you!

1.) There are three general ways that a government can finance its spending. In outline form identify these, which one is most likely to lead to hyperinflation and explain why?

2.) According to the Liquidity Premium Theory (Preferred Habitat) we can see a relationship between the slope of yield curves and the expectations on our future economic activity? For each of the following, what can we expect to happen to future economic activity?

a) A steeply upward sloping yield curve                

b) A mildly upward sloping yield curve

                                            c) A flat yield curve

                                      d) A downward sloping yield curve

Answer 1

1) there are 3 general ways that a government can finance its spending.

a) borrowing from the market: this way government flots government security in the market and people buy it. this way government collect funds from the public and finance its expenditure.

b) foreign loans; some times government also takes loan from foreign markets to finance its expenditure which he repays later with interest.

c) deficit financing or printing currencies: this is one way in which government prints new currencies and use it to purchase things and to finance its expenditure. this is one is most likely to lead to hyperinflation because the economy doesnot produce any additional output for the extra money injected in the economy. the extra money will only increase the price level and will eventually create hyper inflation.

2)The Yield Curve is a graphical representation of the interest rates on debt and a range of maturities. It simply displays the yield an investor is expected to earn if the person  lends his/her money for a given period of time.

a) a steep upward slopping yield curve means  long-term yields are rising at a faster rate than short-term yields. these generally signifies a starting of an expansion period. the steeper curves has a  larger difference between short term and long term return expectations.

b)a mildly upward slopping yield curve is the normal yield curve which shows that  it is riskier to lend money for 30 years, rather than 10 years. here if some one lending his money for a longer period then he is taking more risk and is expects more return from it.

c) a flat yield curve happens when all the maturity of the lending has similar yield. when a yield curve is taking a flat shape it means there is a transition between the normal yield curve and the inverted yield curve.

d) a downward slopping yield curve occurs  when long-term yields fall below short-term yields.  these types of curve occurs due to the perception of long-term investors that yields will decline in the future.