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ECON 442 Problem Set 2 (UMUC)

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Consider a two-period small open endowment economy populated by a large number of
households with preferences described by the lifetime utility function
where C1 and C2 denote, respectively, consumption in periods 1 and 2. Suppose that households
receive exogenous endowments of goods given by Q1 = Q2 = 10 in periods 1 and 2, respectively.
Every household enters period 1 with some debt, denoted B0 , inherited from the past. Let B0
be equal to 5. The interest rate on these liabilities, denoted r0 , is 20 percent. Finally, suppose
that the country enjoys free capital mobility and that the world interest rate on assets held
between periods 1 and 2, denoted r , is 10 percent.
(a) Compute the equilibrium levels of consumption, the trade balance, and the current
account in periods 1 and 2.
(b) Assume now that the endowment in period 2 is expected to increase from 10 to 15.
Calculate the eect of this anticipated output increase on consumption, the trade balance, and
the current account in both periods. Compare your answer to that you gave for item (a) and
provide intuition.
(c) Finally, suppose now that foreign lenders decide to forgive all of the country's initial
external debt. How does this decision aect the country's levels of consumption, trade balance,
and current account in periods 1 and 2. (For this question, assume that Q1 = Q2 = 10 .)
Compare your answer to the one you gave for item (a) and explain.

2. Consider the following chart showing commodity prices in world markets:


Commodity
Wheat
Oil
Price
Period 1 Period 2
1
1
1
2

1
In the table, prices of oil are expressed in dollars per barrel, prices of wheat are
expressed
in dollars per bushel. Kuwait is a two-period economy that produces oil and
consumes wheat.
Consumers have preferences described by the lifetime utility function
U (C1 , C2 ) = C1 C2 ,
where C1 and C2 denote, respectively, consumption of wheat in periods 1 and 2,
measured in
bushels. Kuwait's per-capita endowments of oil are 5 barrels in each period. The
country starts
period 1 with net nancial assets carried over from period 0, including interest of
10 percent,
worth 1.1 bushels of wheat (i.e., (1 + r0 )B0 = 1.1). The interest rate in period 0
is assumed to
be 10 percent (i.e., r0 = 0.1). The country enjoys free capital mobility and the
world interest
rate is 10 percent. Financial assets are denominated in units of wheat.
(a) What are the terms of trade faced by Kuwait in periods 1 and 2?
(b) Calculate consumption, the trade balance, the current account and national
savings in
periods 1 and 2.
(c) Answer the previous question assuming that the price of oil in the second
period is not
2 but 1 dollar per barrel. Compare your answers to this and the previous question
and provide
intuition.

3. [Risk Neutrality] Redo the analysis in section 4.2 of Chapter 4, assuming that households
are risk neutral in period 2. Specically, assume that their preferences are logarithmic in period-1
but linear in period-2 consumption. What would be the predicted eect of the Great Moderation
on the trade balance in period 1?