Problem Set (Chapter 6)
1. Consider an open country of which initial wealth is zero, and its consumers prefer consumption smoothing. The value of output is initially $1 billion. The world real interest rate is 5% and the inflation rate is zero. Suppose output increases by 20% for one period and returns to $1 billion thereafter.
a. Calculate the level of consumption and trade balance in each period.
b. Calculate net factor income account, current account and external wealth in response to the increase in output.
c. Suppose that the 20% increase in output lasts for two periods. Calculate consumption and trade balance in this case.
d. Calculate net factor income account, current account and external wealth in response to the increase in output in Part (d).
2. Consider a country of which initial wealth is zero, and its consumers prefer consumption smoothing. The value of output is initially $1 billion. The world real interest rate is 5% and the inflation rate is zero. There is an investment opportunity which costs $300 million for two periods, and after that it increases output by $40 million every year.
a. Is the investment opportunity worthwhile? Explain your reasoning.
b. Calculate consumption and trade balance if this investment opportunity is pursued.
c. Calculate net factor income account, current account and external wealth if this country pursues this investment opportunity.
3. Consider the world with two countries: Country A and Country B. There are two states of the world: State 1 and State 2. In State 1, output of Country A is $100 billion, and output of Country B is $80 billion. In State 2, output of Country A is $70 billion, and output of Country B is $120 billion. Assume that the share of labor income in output is 70% for Country A and 60% for Country B, respectively.
a. Derive the income distribution in each country in each state when there is no foreign direct investment.
b. Consider foreign direct investment such that residents in each country hold 50% of domestic portfolio and 50% of foreign portfolio. Derive the income distribution in each country in each state in this case.
c. Based on your answers in Parts (a) and (b), does foreign direct investment help residents in the two countries diversify income risk? Explain your reasoning.