2a.Outland starts a given year with holdings of 100 shares of Volk, denominated in euros.

The rest of the world holds 200 where (Q1, Q2:output in periods 1, 2; I0 ,I1: the capital stock in periods 1, 2, A1 and A2: productivity factors in periods 1and
units of dollar-denominated bonds issued by the Outlandian gov- ernment. At the beginning of the year, the price of each 2, and α: aparameter. I0=16,A1 =3,33,A2 =3.2, α=3/4. Beginning of period 1, households have B0h = 8 bonds. Interest rate on
Volkswagen share is €1 and the price of each unit of an Outlandian bond is $2. The exchange rate is $1.5 per euro. Compute bonds held from period 0 to period 1 is 𝑟 = 0.25. In period 1, firms borrow the amount D1f to purchase investment goods that
0
the net international investment position (NIIP) of Outland at the beginning of the year. become productive capital in period 2, I1. Assume that there exists free international capital mobility’ world interest rate,
A = 100 × 1 × 1.5 = $150, L = 200 × 2 = $400, NIIP = A − L = −$250
denoted r∗, is 20%(a) Compute output and profits in period 1.𝑄1 = 𝐴1 𝐼0α = 80/3. Π1 =Q1 −(1+𝑟0 )I0 = 20/3
b.During the year, Outland exports toys for $7 and imports shirts for €9. The dividend payments on the Volkswagen shares
were €0.05 per share and the coupon payment on Outlandian bonds was $0.02 per bond. Residents of Outland received money (b) Compute the optimal levels of investment in period 1 and output and profits in period 2.
from relatives living abroad for a total of €3 and the government of Outland gave $4 to a hospital in Guyana. Calculate the The optimal level of investment 𝐴2 𝐼0α = 1 + 𝑟 ∗ → I1=16 → 𝑄2 = 𝐴2 𝐼0α = 25.6 → Π2 =Q2 −(1+r∗) I1 =6.4
Outlandian trade balance, net investment income, and net unilateral transfers in that year. Current account in that year? (c)The optimal levels of consumption in periods 1, 2. Euler equation requires that 1/C1 = (1 + r∗)/C2; 1.2C1 = C2.
Outlandian NIIP at the end of the year? TB = 7 − 9 × 1.5 = −$6.5, NII = e0.05 × 100 × 1.5 − $0.02 × 200 = $3.5, 𝐶2 Π2∗
Intertemporal budget constraint: C1 +1+𝑟 C2∗ = Π 1 + 1+𝑟 + (1 + r0)𝐵0ℎ . → 2C1= 22 → C1 = 11, C2 = 13.2.
NUT = e3 × 1.5 − $4 = $0.5, CA = −6.5 + 3.5 + 0.5 = −$2.5, NIIP =−250 − 2.5 =−$252.5 1∗ ∗

c. End of the year, Outland holds 110 Volk shares. How many units of Outlandian government bonds are held in the rest of the (d) Find the country’s net foreign asset position at the end of period 1, denoted B1, saving, S1, the trade balance, TB1, and the
world? All financial transactions were performed at beginning- of-year prices and exchange rates. current account, CA1.
ℎ 𝑓 𝑓 ℎ ℎ
Change in NIIP = Change in A - Change in L → −2.5 = 10 × 1 × 1.5 − 2×(change in the number of government bond held in B1 = 𝐵1 .- 𝐷1 where 𝐷1 = I1 → I1 = 16 is already. 𝐵1 can be computed from the period 1 budget constraint. 𝐵1 = Π1 − C1 +
the rest of the world) → Change in the number of government bond=8.75 (1 + r0) 𝐵0ℎ = 17/3. =>, B1 = 17/3−16 = −31/3. Saving is S1 = r0(𝐵0ℎ −I0)+Q1 −C1 = 41/3. The current account is the
d.End of the year, the price of a Volk share falls by 20% and the dollar appreciates by 10%. Calculate the end-of-year NIIP of difference between S1 and I1. → CA1 = −7/3. The trade balance can be computed by CA1 − r0B0 = −1/3.
Outland. A = 110 × 0.8 × 1.35 = $118.8, L = 208.75 × 2 = $417.5, NIIP = 118.8 − 417.5 =−$298.7 (e) Consider an interest rate hike in period 1. Asume that as a result of turmoil in international financial markets, world
3.The international asset position of country 1, denoted A, consists of $10 in bonds is- sued by the government of country 2, interest rate increases from 20 % to 50 % in period 1. Find the equilibrium levels of saving, investment, the trade balance, the
and $20 in shares of firms residing in country 2. The international liabilities of country 1 (L) consist of $35 in bonds issued by current account, and the country’s net foreign asset position in period 1.From the Euler equation, 1/C1 = 1.5/C2 and 1.5C1 =
the government of country 1 and held by foreign residents, and $5 in shares of firms residing in country 1 held by foreigners. C2 holds. From the firm’s optimal investment choice α𝐴2 𝐼1α−1 = 1.5. → I ≈ 6.55. Based on the investment decision, Q2 ≈
The rate of return on government bonds is 2% and that the rate of return on shares is 6% (a)Calculate the net international 13.11 and the profit in the period-2 is given by Π2 = Q2 − (1 + r∗)I1 ≈ 3.28. Combining the Euler equation and the
investment position (NIIP) and net investment income (NII).NIIP = A−L = 30−40 = −$10, NII = rG×10+rS ×20−(rG×35+rS ×5) intertemporal budget constraint, C1 ≈ 9.43 and C2 ≈ 14.15 can be obtained. Saving can be computed as S1 = r0B0 + Q1 − C1
= $0.4 ≈ 15.24. The current account is the difference between saving and investment: CA1 = 15.24 − 6.55 = 8.69. The trade balance
b.NIIP and NII of country 1 ( in (a), but not the rate of return on bonds and shares. Explanation NIIP and NII is dark matter. can be derived by TB1 = CA1 − r0B0 = 10.69. The net foreign asset position is B1 = 𝐵ℎ −I1 = Π1 +(1+r0) 𝐵ℎ −C1 −I1 ≈ 0.69.
1 0
Assuming a rate of return of 3% on all assets, how big is dark matter and “true” net international investment position, TNIIP, the relative price of consumption in period-1 becomes more expensive than consumption in period 2→ saving increases. Same
in country 1? TNIIP × 3% = NII, TNIIP = 0.4/0.03 = $40/3, dark matter= 40/3 −(−10) =$70/3
time, firms cut down their investment as the interest rate increases. → the trade balance and the current account improve.
4.Over the period 2020 to 2022, the net international investment position of a country was NIIP2020 = 100, NIIP2021 = 125, and (f) Interest rate is 20%, and that A1 increases to 4. Calculate the equilibrium values of output, consumption, saving,
NIIP2022 = 130. Current account was CA2020 = 30, CA2021 = 20, and CA2022 = 10. Calculate valuation changes in 2021 and 2022. investment,and the current account in period 1. Q1 increases to 32 as A1 rises. Π1 also rises to 12.8. # A1 does not affect the
Hypothetical NIIP computed from CA: HNIIP2021 = 100 + 20 = 120, HNIIP2022 = 120 + 10 = 130. The differences between
firms’ investment choice for I1 , and =>Q2 and Π2 . Therefore, I1 , Q2 , and Π2 remain at the same level. The Euler equation
NIIP and HNIIP are cumulative valuation changes up to that year. =>, valuation changes in 2021 and 2022 are 5 and -5. (2rd
also remains the same (1.2C1 = C2). #, the lifetime welfare, which is the right-hand side of the intertemporal budget constraint
method) change in NIIP = CA + valuation change. In 2021, the change in NIIP was 25 and the CA was 20. → valuation
changes as Π1 increases → C1 ≈ 14.07 and C2 ≈ 16.88. 𝑺𝟏 = 𝒓𝒐 (𝑩𝒉𝟎 −I0)+Q1 −C1 and Q1, C1 have been changed. So S1 ≈
change in 2021 was 5.
15.93. Finally, CA1 = S1 − I1 ≈ −0.07. As the productivity temporarily increases, the output and consumption, and saving
5.Net investment income is NII = 200, the international asset position is A = 3000, the international liability position is L =
4000, and the rate of return is 5%, r = 0.05. a.Economist J, a strong advocate of the dark matter hypothesis, believes that A is increase. the households become wealthier and want to smooth consumption. → saving rises. The level of investment will not
not accurately recorded. Calculate the amount of dark matter and the “true” international asset position, which we will denote change as the investment depends only on the interest rate today and the productivity tomorrow.
TA, consistent with J’s view. TNIIP=NII/r=4000, dark matter= 4000 − (−1000) = 5000, TA = A + 5000 = 8000 (g) Interest rate is 20% that A1 = 331, and that A2 increases from 3.2 to 4. Calculate the equilibrium values of consumption,
b.Financial analyst N does not believe in the dark matter hypothesis. Instead, she believes that A is accurately measured. In saving, investment, and the current account in period 1.
her view 5% is actually the rate of return on assets rA = 0.05, and the rate of return on the country’s international liabilities, rL, Q1 and Π1 do not depend on A2. Therefore, 𝛂−𝟏
they remain at the same level. Since optimal investment choice I1 depends on A2,
is different. Find the value of rL consistent with N’s view. NII = A × rA − L × rL, 200 = 3000 × 0.05 − 4000 × rL, rL = −1.25% we use the following to find I1. 𝛂𝑨𝟐 𝑰𝟏 = 1+r = 1+r∗. The last equality again comes from the interest parity condition. => I1
6.In a two-period economy, saving in periods 1 and 2 is 5 (S1 = S2 = 5) and investment in both periods is 10 (I1 = I2 = 10). ≈ 39.06. Putting this to the production function, Q2 = 62.5.
a.Current account in periods 1 and 2 (CA1 and CA2)? CA=S-I. Therefore, CA in period 1 and 2 are both -5. As a result, Π2 ≈ 15.63. The Euler equation remains the same: 1.2C1 = C2. The lifetime wealth, which is the right-hand side
b. Initial net international investment position (B0) Since B0 = −CA1 − CA2, B0 = 10 of the intertemporal budget constraint becomes Π1 + Π2∗ +(1+𝑟𝑜 ) ≈ 29.69 and this should be equal to the 1+r left-hand side of
c.Interest rate is 4%(r = 0.04), trade balance in periods 1 and 2 (TB1 and TB2)? the intertemporal budget constraint 2C1. Therefore, C1 ≈ 14.85 and C2 ≈ 17.82. Saving becomes S1 = 𝑟𝑜 (𝐵0ℎ − I0) + Q1 − C1
CA1 = TB1 + r × B0. =>, −5 = TB1 + 0.04 × 10. So, TB1 = −5.4 ≈ 9.82. → CA1 = S1 −I1 ≈ −29.24. As the productivity is anticipated to increase tomorrow, the households become richer in
CA2 = TB2 + r × B1 = TB2 + r × [(1 + r) × B0 + TB1] → −5 = TB2 + 0.04 × [1.04 × 10 − 5 × .4]. Therefore, TB2 = −5.2 terms of their lifetime income. Therefore, they want to increase their consumption today. #, output remains the same → they
7.NIIP2020 = −14721.0, NIIP2021 = −18832.5, NIIP2022 =−16263.9, CA2021 = −868.0, CA2022 = −1012.1 → VC2021 = NIIP2021 need to borrow from the international financial market. Firms also want to borrow more as investing now becomes more
− NIIP2020 − CA2021 = −3243.5; VC2022 = NIIP2022 − NIIP2021 − CA2022 =3580.7 profitable, leading to increase in investment. In this reason, the current account deteriorates.
3.US experiences an increase in grain production in period 1. Use a graphical approach to analyze the effect of this shock on
1.Consider a two-period economy populated by households with preferences described by the utility function √𝐶1 + √𝐶2
The household starts period 1 with zero assets (B0 = 0) and receives endowments Q1 = 2 and Q2 = 4 in periods 1, 2. The the current account, saving, investment, world interest rate in the US and in a small open economy such as El Salvador. →The
exceptionally good weather in period 1 can be interpreted as an increase in period 1 productivity. As the US becomes richer,
economy has free capital mobility, and world interest rate is zero, r∗= 0. Calculate the equilibrium levels of consumption and the households in the US can increase consumption and saving in period 1 → the saving schedule shifts to the right. As A1
′
the trade balance in period 1 (C1 and TB ).(Hint:U(C)= √𝐶 ⇒U (C)= 2√𝐶 ) β = 1; r∗ = 0, the first order optimality condition does not affect the investment choice, the investment schedule remains the same. → the current account schedule shifts to the
1

1 1 1 right: given interest rate, the current account improves. → world interest rate decreases and investment and saving increase.
becomes 2√𝐶1 = 2√𝐶2 → the optimal level of consumption in period 1 and 2 are the same. C1∗ = C2∗ .The intertemporal budget For a small open economy, this shock can be considered as a decreasing world interest rate shock. Therefore, saving increases
constraint gives C1 +C2 =Q1 +Q2 =6.The last equality comes from the endowment assumed in problem →C1∗ =3 ;TB1 =Q1 while investment decreases. →The current account improves.
−C1 =2−3=−1 4.Consider a two-period, two-country, endowment economy. US(U), Europe (E). Households in U have preferences described
by the utility function ln𝐶1𝑈 +ln𝐶2𝑈 where (𝐶1𝑈 , 𝐶2𝑈 :consumption of U.S. households in periods 1,2. Europeans have identical
2. Consider a small open economy where households live for two periods and have logarithmic preferences, lnC1 + βlnC2, preferences, given by ln𝐶1𝐸 +ln𝐶2𝐸 where (𝐶1𝐸 , 𝐶2𝐸 :consumption of European households in periods 1,2, QU1 a denote the U.S.
where the subjective discount factor β equals 10/11. Households receive a constant endowment over time equal to 10, Q1 = endowments of goods in periods 1,2. Similarly, let 𝑄1𝐸 , 𝑄2𝐸 European endowments of goods in periods 1,2. Assume further that
Q2 = 10. Households start period 1 with debt including interest equal to 5, (1+𝑟𝑜 ) 𝐵𝑜 = −5 and that 𝑟𝑜 = 0.1. Country enjoys the endowments are nonstorable, that the U.S. and Europe are of equal size, and that there is free capital mobility between the
free capital mobility and that world interest rate is 10%, r∗ = 0.1. (Hint: U(C) = lnC ⇒ U′(C) = C1) From the Euler equation two economies. The USstarts period 1 with a zero net foreign asset position. 𝑄𝑈 = 𝑄𝑈 = 𝑄𝐸 = 𝑄𝐸 = 10. Calculate the
1 1+𝑟 1 2 1 2
(the first order optimality condition), =β 1 Put 𝑟1 = r∗ = 0.1 and β = 10/11, C1∗ = C2∗. The intertemporal budget equilibrium world interest rate, and the current accounts in the USand Europe in period 1.
𝐶1 𝐶2
𝐶2 𝑄2 𝑄 𝑈 +𝑄𝐸 1 𝑄 𝑈 +𝑄𝐸 𝑄𝑈 𝑄𝑈
constraint gives 𝐶1 + 1+𝑟 =𝑄1 + 1+𝑟 + (1 + 𝑟0 ) B0 → Derive the optimal consumption in period 1. C1∗ = 15.5/2.1 ≈ 7.38;The 1+r∗ = 𝑈2 2𝐸→ r∗ =0. 𝐶𝐴1𝑈 = 1𝐸 2𝐸 ( 1𝐸 − 2𝐸 )The current accounts for both countries are 0.
1 1 𝑄1 + 𝑄2 2 𝑄2 + 𝑄2 𝑄1 𝑄2
trade balance can be computed by the difference between the endowment and the consumption TB1 =Q1 −C1 =10−7.38≈2.62 (b) A contraction originates in the United States. Specifically, assume that 𝑄1𝑈 drops from 10 to 8. All other endowments
The current account is the sum of the trade balance and the net investment income 𝑟𝑜 𝐵𝑜 . Compute B0 from (1 + r0) B0 = −5. As (𝑄2𝑈 = 𝑄1𝐸 = 𝑄2𝐸 ) remain unchanged at 10. This contraction in output has two characteristics: First, it originates in the US(the
𝑟𝑜 = 0.1, B0 = 4.55→ CA1 ≈ 2.62 − 0.46 = 2.16. European endowments are unchanged). Second, it is temporary (the U.S. endowment is expected to return to its normal value
(b)Foreign lenders decide to forgive all of the country’s initial external debt including interest. Calculate the effect of this of 10 after one period). Calculate the equilibrium interest rate and the current accounts of the US and Europe in period 1.
external gift on consumption, the trade balance, and the current account in period 1. The optimality condition remains 𝑄 𝑈 +𝑄𝐸
𝐶2 𝑄2 1 + r∗ = 𝑈2 2𝐸 = 20 . Therefore, r∗ ≈ 0.11. The US current account becomes -0.5 using the CA determination equation above.
unchanged: C1∗ = C2∗. The intertemporal budget constraint becomes 𝐶1 + 1+𝑟 =𝑄1 + 1+𝑟 → C1∗ = C2∗ = 10 →trade 𝑄1 + 𝑄2
1 1 Since there are two countries in the world, the European current account will be 0.5. the incentive to borrow rises in the US as
balance and the current account all becomes to 0. Because of the forgiveness, the households become richer → consume more.
the endowment today is smaller than the endowment in tomorrow → world interest rate needs to be increased to make Europe
3.Consider a two-period, small open economy populated by households whose preferences are given by lnC1 + lnC2, (C1,C2: want to save.
denote consumption of food in periods 1, 2. Households are endowed with 1 ton of copper in each period and start period 1 (c) Consider a second type of contraction in which the U.S. endowment falls from 10 to 8 in the first period and is expected to
with a zero net asset position. The relative price of copper in terms of food is 1 in both periods, and world interest rate is zero. continue to fall to 6 in the second period (𝑄𝑈 = 8, 𝑄𝑈 = 6). The endowments in Europe remain unchanged at 10 each period
1 2
( The terms-of-trade needs to be defined as the price of copper divided by the price of food.) a.Consumption, trade balance in (𝑄𝐸 = 𝑄𝐸 = 10). Like the one described in the previous item, this contraction originates in the US. # it differs from the one
1 2
periods 1 and 2?The first order condition states that C1∗= C2∗. intertemporal budget constraint becomes C1 + C2 = TT1Q1 + described in the previous item in that it is more protracted. Calculate again the equilibrium interest rate and the two current
TT2Q2 → C1 = C2 = 1 and TB1 = TB2 = 0.
∗ ∗
accounts in period 1.
b. Period 1 the relative price of copper continues to be 1, but that the expected relative price of copper in period 2 increases Using the same equations . r∗ ≈ −0.11 and 𝐶𝐴𝑈 = 0.625. Then, 𝐶𝐴𝑈 = −0.625. US want to save in period 1 since the
to 1.5. Calculate consumption,trade balance in both period. C1∗ = C2∗ → The intertemporal budget constraint becomes C1 + endowment is expected to drop more in period12. That means that 1there should be an incentive to make Europe borrow more.
C2 = TT1Q1 + TT2Q2 = Q1 + 1.5Q2 = 2.5. → C1 = C2 = 1.25 and TB1 = −0.25, TB2 = 0.25.
∗ ∗
→ world interest rate need to be lowered. US needs to offer even a negative interest rate to make Europe borrow from the US.
c. Assume that in period 1 the relative price of copper is 1 and households are 100% sure that the relative price of copper in As a result, the current account of the US in period 1 improves while that of the Europe deteriorates.
period 2 is going to be 1.5. #, assume that when period 2 arrives, expectations are not fulfilled, and the price remains at (d)At the beginning of the Great Recession of 2008, interest rates fell sharply around the world. The decline in world interest
1.Consumption and the trade balance in periods 1 and 2? Provide intuition. C1∗ = 1.25, TB1 = −0.25. From the period 1 rate observed in that time is consistent with the scenario that the US economic downturn gets worse in our current account
budget constraint, B1 =TT1Q1 − C1 = 1 − 1.25 = −0.25. Putting this into the period 2 budget constraint,C2 = B1 + TT2Q2 = determination model.
−0.25 + 1 = 0.75. TB2 = 0.25. Initially, the households expected to become richer in period 2 as the terms of trade -NIIP= Foreign asset position (A) – Foreign liability position (L) | If NIIP is negative (A<L): the country is a net debtor to the
improves. → they increased their consumption in the 1st period, borrowed against their future income which was expected rest of the world | If NIIP is positive (A>L): the country is a net creditor to the rest of the world
to increase. #, in period 2, the TT does not improve. While they do not become richer as expected, they still need to honor -Change in the NIIP are not always exactly equal to the change in the CA | 1. Not only source of changes in the net
their borrowings→ trade balance should be positive to repay the debt → cut consumption in the second period even further. international investment position | NIIP can also change when the market value of a country’s international assets or liabilities
4.Consider a two-period open economy in which households have preferences given by ln C1 +ln C2 (C1, C2: consumption of changes due to movement in stock prices, bond prices, exchange rate.
food in periods 1,2, in tons. The country does not produce food. Households are endowed with C1 and C2 barrels of oil in - Valuation change: + Assets (A) 25 shares, the price of each share is 2 euros. The exchange rate is 2$ per euro → A = 25 x 2
periods 1 and 2. In both periods, a barrel of oil sells for one ton of food in international markets. Economy starts period 1 with x 2 = 100$ | Liabilities(L) 80 US bonds held by foreigner. Price 1 dollar per unit → P= 80 x 1 = 80$
no assets, B0 = 0. World interest rate is r∗ and there is free capital mobility. The government imposes tariffs on food imports in - Reason US stocks have outperformed foreign stocks: 1. Every time the US stock market goes up, the value of US portfolio
periods 1 and 2, denoted τ1 and τ2, and rebates the revenue generated by the tariffs to the public using lump-sum transfers, equity liabilities (US stocks held by foreign investors) increases 2. As US stock outperform foreign stocks, the value of the US
𝑃𝑜𝑖𝑙
denoted L1 and L2. (a)The terms of trade in periods 1, 2: TT1 =TT2 =𝑃𝑓𝑜𝑜𝑑 net foreign portfolio equity position goes down, the US suffers valuation losses
(1+τ2)C2 Q L TNIIP: the true net international investment position, NIIP: the observed net international investment position, NII: net
(b)Derive the household’s intertemporal budget constraint.(1+τ1)C1+ 1+𝑟 = Q1+1+𝑟2 + L1+1+𝑟 2
investment income (0.1909 in 2020) Net investment income is the return on the True Net international investment position →
1 1 1
(c)The optimization problem of household. max ln C1 + ln C2 subject to the intertemporal budget constraint shown in (b). r: interest | NII = r x TNIIP → TNIIP = NII/r = 0,1909 / 0,05= 3,8 tri |Dark matter = TNIIP – NIIP = 3,8 – (-11.1) = 14.9
1 1+τ1 1+𝑟1 -How will the household adjust to the temporary negative output shock? Assume that both C1 and C2 are normal goods.
(d) Derive the first-order conditions of the household’s optimization problem. =
C1 1+τ2 C2 ( goods whose consumption increases with income) Then the household would want to cut both C1 and C2. By also cutting
(e) Write down the budget constraints of the government in periods 1 and 2. τ1C1 = L1, τ2C2 = L1 (f) Combine the C2, the household does not need to cut C1 by ∆ but by less. In smoothing consumption over time, the country runs a larger
household’s intertemporal budget constraint with the government budget constraints to find the economy’s intertemporal trade deficit in period 1 (recall that it was running a trade deficit even in the absence of the shock!) and finances it by
resource constraint in equilibrium. Do the policy variables τ1, τ2, L1, or L2 appear in constraint? acquiring additional foreign debt→ the current account deteriorates. In period 2, the country must generate a larger trade
C Q
C1+1+𝑟 = Q1 1+𝑟 → do not appear because the tax revenue is reimbursed to households
2 2 surplus than the one it would have produced in the absence of the shock in order to pay back the additional debt acquired in
1 + 1 period 1.
(g) Let Y ≡ Q1 + Q2/(1 + r∗) denote present discounted value of the endowment path. Express equilibrium values of Income Effect: If households are borrowing, the interest rate hike makes them poorer (income effect is negative) →
Y Y(1+r∗) 1+τ1
consumption in period 1, 2 in terms of Y, r∗, τ1, and τ2. C1= 1+τ1 , C2 1+τ1 ( ) consumption falls and saving increases. In this case, the income and substitution effects reinforce each other.
1+
1+τ2 = 1+ 1+τ2 1+τ2 If households are lending, the interest rate hike makes them richer (income effect is positive) → consumption increases and
(h) Write the equilibrium trade balance in period 1 in terms of Y , r∗, Q1, τ1, and τ2 Compare the trade balance under free saving falls. In this case, the income and substitution effects oppose each other.
trade, i.e., τ1 = τ2 = 0, (a)τ1 =τ2 >0 → 𝑇𝐵1𝑎 = 𝑇𝐵1𝐹𝑇 ; (b)τ1 >0 and τ2 =0 → 𝑇𝐵1𝑎 > 𝑇𝐵1𝐹𝑇 ;(c)τ1 =0 and τ2 >0. → 𝑇𝐵1𝑎 < 𝑇𝐵1𝐹𝑇 If households are borrowing, an increase in the interest rate has a negative income effect, as it makes borrowers poorer. As a
1. Period 1, unexpectedly the initial interest rate increases from r0 to 𝑟0∗ > 𝑟0 > 0. If in period 0 households took debt at a result, consumption falls and the trade balance and the current account improve. In this case, the income and substitution
floating (as opposed to a fixed) interest rate. Present a graphical analysis of the effects of this shock on consumption, saving, effect go in the same direction. If households are lending, the income effect associated with an increase in the interest rate is
investment, and the current account in period 1. Distinguish the case in which the country is initially a net creditor of the rest positive and leads to higher consumption and a deterioration in the trade balance and the current account. In this case, the
of the world (B0 > 0) from the case in which the country is initially a net debtor (B0< 0). ( S1 = S(r1;A1,A2) because we did income and substitution effects go in the opposite direction, partially offsetting each other. Under log-preferences the
not consider changes in 𝑟0 . But 𝑟0 also affects saving, so one could write S1 = S(r1; A1, A2, r0).) substitution effect dominates.
Consider the case that the country is initially a net creditor (B0 > 0). Then the increase in the initial interest rate provides an -Effect of an increase in the interest rate: marginal cost schedule up
additional interest income to the country at period-1. Its impacts on the economy are similar to a temporary increase in - The positive productivity shock shifts the investment schedule up and to the right because for every level of the interest rate,
endowment or productivity. → consumption in the first period increases. This can be graphically shown as the intertemporal the profit-maximizing level of investment is now higher.
budget constraint line expands outward. As households become richer in the 1st period, they save more in period 1 in order to -The anticipated positive productivity shock increase period 2 profits | The increase in period 1 consumption is financed by an
make their consumption path smooth. The firms’ investment decision is not affected by the change in the initial interest rate. increase in borrowing | The increase in the interest rate gives rise to 2 negative income effects and 1 substitution effect all
→ investment would not change. The current account improves as the country saves more. For the case of net debtor, lowering period-1 consumption.
everything opposite. -The saving schedule: slopes upward because an increase in the interest rate induces households to postpone current
2.Consider a two-period model of a small open economy with a single good each period. Let preferences of the representative consumption and increase their holdings of interest-bearing assets
household be described by the utility function lnC1 +lnC2 (C1,C2:consumption in periods 1,2, Π1 Π2: Each period the -Equilibrium Current Account if the U.S. endowment in period 1 is large relative to that of the rest of the world compared
household receives profits from the firms it owns, r1: Households and firms have access to financial markets where they can to the relative endowments in period 2, U.S. households end up sharing part of their relatively abundant period-1 endowment
borrow or lend at the interest rate. The production technologies in periods 1 and 2 are given by 𝑄1 = 𝐴1 𝐼0α and 𝑄2 = 𝐴2 𝐼0α with the rest of the world.