Assume That Initially, the Risk Premium, ρ = 0 and That

Essay

Assume that initially, the risk premium, ρ = 0 and that the domestic and foreign interest rates are given by R = .06, R* = .05. Suppose that the risk premium depends linearly on the difference between domestic government debt, B, and domestic assets of the central bank, A, i.e.
ρ = ρ^(B-A)
Find the new domestic interest rate if a sterilized purchase of foreign assets adjusts A s.t.
(a) B - A = -.01/ ρ_o
(b) B - A = .01/ ρ_o
(c) B - A = .03/ ρ_o