Q1. 10 p Consider a two-period model of a small open economy with a single good
ID: 1173971 • Letter: Q
Question
Q1. 10 p
Consider a two-period model of a small open economy with a single good each period. Let preferences of the representative household be described by the utility function
ln(C1) + ln(C2),
where C1 and C2 denote consumption in periods 1 and 2, respectively, and ln denotes the natural logarithm. In period 1, the household receives an endowment of Q1 = 5. In period 2, the household receives profits, denoted by ?2, from the firms it owns. Households and firms have access to financial markets where they can borrow or lend at the interest rate r1. (r1 is the interest rate on assets held between periods 1 and 2.).
Representative firm borrows D1f in period 1 to make investment I1 that enable the firm to produce goods in period 2. The production technology in period 2 is given by
Q2 = ?(I1),
where Q2 and I1 denote, respectively, output in period 2 and investment in period 1.
Assume that there exists free international capital mobility and that the world interest rate, r*, is 10% per period (i.e., r* = 0.1). Finally, assume that the economy’s initial net foreign asset position is zero (B0* = 0).
c) Find the country’s net foreign asset position at the end of period 1, the trade balance in periods 1 and 2, and the current account in periods 1 and 2.
d) Now consider an investment surge. Specifically, assume that as a result of a technological improvement, the production technology becomes Q2 = 2?(I1). Find the profit maximizing level of investment made in period-1 and the level of profit for period-2. Find the equilibrium levels of saving, the trade balance, the current account, and the country’s net foreign asset position in period 1.
c) Find the country's net foreign asset position at the end of period 1, the trade balance in periods 1 and 2, and the current account in periods 1 and 2. d) Now consider an investment surge. Specifically, assume that as a result of a technological improvement, the production technology becomes Q2 2(1). Find the profit maximizing level of investment made in period-1 and the level of profit for period-2 Find the equilibrium levels of saving, the trade balance, the current account, and theExplanation / Answer
Policy measures that affect international capital flows have led to considerable controversy in international policy circles. Capital controls or reserve accumulation in one country leads to significant international spill over effects via lower world interest rates and greater flows to other countries.
If a country imposes capital controls in the form of taxes on borrowing from abroad ,it reduces borrowing and consumption and depreciates its real exchange rate.At the same time.it pushes down the world interest rates which induces other countries to borrow and spend more.The decline in the world interest rate increases the welfare of all net borrowers and hurts all net lenders in the world economy.
When capital accounts are open for the borrowing/lending transactions of private agents , we derive a Ricardian equivalence result for reserve accumulation, I.e it will be undone..When capital accounts are closed for private transactions ,reserve accumulation determine the level of international borrowing and lending.
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