Consider the intertemporal model with two time periods. Home is a small open economy that can borrow and lend in the first period at a fixed world real interest rate of r* = 4%. In the first period output is Q0 = 800. Because of a recession, output in the second period output is expected to fall to Q1 = 500. The country wants to smooth consumption as much as possible. The country begins with no external assets or liabilities. Finally, assume that the intertemporal utility function at home is u(c0) + βu(c1) where β = 1/1+r* u is concave (i.e. consumers are risk averse and want to smooth consumption). (a) Solve for consumption, the current account, and financial account in the first period (t = 0). (b) Solve for the trade balance, current account, and financial account in the second period (t = 1). (c) Would Home be better off or worse off if the world interest rate is 1% instead of 4%? Explain using the appropriate equations.
Consider the intertemporal model with two time periods. Home is a small open economy that
can borrow and lend in the first period at a fixed world real interest rate of r* = 4%. In the
first period output is Q0 = 800. Because of a recession, output in the second period output is
expected to fall to Q1 = 500. The country wants to smooth consumption as much as possible.
The country begins with no external assets or liabilities. Finally, assume that the intertemporal
utility function at home is
u(c0) + βu(c1)
where β = 1/1+r*
u is concave (i.e. consumers are risk averse and want to smooth consumption).
(a) Solve for consumption, the current account, and financial account in the first period (t = 0).
(b) Solve for the trade balance, current account, and financial account in the second period
(t = 1).
(c) Would Home be better off or worse off if the world interest rate is 1% instead of 4%?
Explain using the appropriate equations.
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