Assignment

1. Consider a two-period model of a small open economy with a single good each period. Let preference of the representative household be described by the utility function

U(C₁,C₂) = In(C₁) + In(C₂)

where C₁ and C₂ denote consumption in periods 1 and 2, respectively, and In denotes the natural logarithm. In period 1, the household receives an emlowntait of Q₁ = 10. In period 2, the household receives profits, denoted by 2, from the finns 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.). Finns invest in period 1 to be able 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 (B*0 = 0).

(a) Compute the firm's optimal levels of period-1 investment and period-2 profits.

(b) State the maximization problem of the representative household and solve for the optimal levels of consumption in periods 1 and 2.

(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 equilibrium levels of savings, investment. the trade balance, the current account, and the country's net foreign asset position in period 1. Compare your results with those obtained in items (a)-(c) providing interpretation and intuition.