Chap 6

Question 1

What is Consumption smoothing ?

Answer 1

• The steady consumption when income fluctuate

Question 2

what is Efficient investment ?

Answer 2

• The borrowing to build a productive investment

Question 3

What is diversification of risk?

Answer 3

• The trade of stocks between countries

Question 4

What is LRBC ?

Answer 4

• Long- run budget constraint
• I tell us the ability to borrow (in times of need ) and the ability lend (in times of prosperity ) in the long run
• It uses change in an economy’ external wealth to determine the limits of borrowing in the long run

Question 5

what is a “debt that is not served” ?

Answer 5

• When the interest payment or the principal is pay

Question 6

what is a debt that is serviced ?

Answer 6

• When ONLY the interest is pay

Question 7

What mayor assumption is in the LRBC ?

Answer 7

• Small open economy
• Real economy
• World interest rate
• Start period payment
• No unilateral transfer (NUT = 0) and no capital transfer (KA = 0)
• current account only affected by TB and NIF

Question 8

Explain the assumption of small open economy in LRBC?

Answer 8

• The country is. price taker

- It cannot influence prices or real interest rate

Question 9

Explain the assumption of real economy in LRBC ?

Answer 9

• Prices are perfectly flexible

- The analysis in real variables and we ignore monetary aspect of the economye

Question 10

Explain the assumption of World real interest rate in LRBC ?

Answer 10

• the assumption is that it is constant

- a country can borrow unlimited amount at this interest

Question 11

Explain the assumption of start period payment in LRBC ?

Answer 11

• The assumption that payment are done at the start of the period (fiscal year)

Question 12

Explain the assumption of NUT and KA in LRBC ?

Answer 12

• The assumption that there is no capital transfer or capital gains on external wealth

Question 13

Formula for Change in Wealth (per period) :

Answer 13

Wn = Wn - Wn-1 = TBn + r* ( Wn-1)

Wn - Wn-1 : change in external wealth

TBn : Trade balance (this period)

r* ( Wn-1) : interest paid/ received ( on the last period’ s external wealth)

r*: interest rate

Question 14

Formula for Future Wealth Levels :

Answer 14

Wn = TBn + (1 + r*) Wn-1

Wn : External wealth at the end of this period

TBn : Trade balance (this period)

(1 +r*) Wn-1 : Last period’s external wealth ( plus interest paid/ received)

r*: interest rate

Question 15

Formula for Two-period budget constraint : (inconpleto)

Answer 15

• (1 + r)^2 . W-1 = (1 + r) TB0 + TB1

r*: interest rate

Question 16

Formula for PV form :

Answer 16

• ( 1 + r) W-1 = TB0 + (TB1 / 1+r )
• ( 1 + r*) W-1 : Minus the present value of wealth (from last period)

TB0 + (TB1 / 1+r* ) : Present value of all present and future trade balances

r*: interest rate

Question 17

Formula for PV in the long run :

Answer 17

• ( 1 + r) W-1 = TB0 + (TB1 / 1+r ) + (TB1 / 1+r* )^2 + …

Question 18

Formula for PV perpetual loans :

Answer 18

( X / 1+r* ) + ( X / 1+r* )^2 + ( X / 1+r* )^3 + … = X / r*

Question 19

Formula for LRBC ( TB = GPD - GNE):

Answer 19

PV GNE = ( GNE / 1+r* ) + ( GNE / 1+r* )^2 + ( GNE / 1+r* )^3 + …

Also the theory indicated that it is equal to the GDP

( 1 + r)W-1 + ( GDP / 1+r ) + ( GDP / 1+r* )^2 + ( GDP / 1+r* )^3 + …

Present value of wealth + PV GDP (present and future)

Question 20

Complete formula for Change in Wealth:

Answer 20

Wn = Wn - Wn-1 = TBn + r* ( Wn-1) + (r*-r0 ) L + KG

Wn - Wn-1 : change in external wealth

CONVENTIONAL EFFECTS
TBn : Trade balance (this period)

r* ( Wn-1) : interest paid/ received ( on the last period’ s external wealth)

r*: interest rate

ADDITIONAL EFFECTS
(r*-r0 ) L : Income due differential in interest rate 

KG : capitals gains from abroad

Question 21

Can countries used their external wealth as a buffer ? and why ?

Answer 21

• Yes , the purpose is to smooth consumption in the face of fluctuations (in output or investment )
• However, each country have limits : debts

Question 22

What happens with smooth consumption levels when a shock is permanent ?

Answer 22

• Consumers smooth out temporary shocks

- Adjustment is far smaller of the shock (immediately and fully complete)

Question 23

What it means “save for rainy days “ in financial openness context ?

Answer 23

• Using financial institutions to smooth consumption fluctuations
• In open economy, a desire consumptions path (without effect of fluctuations) can be achieved by having trade deficits .
• In close economy Q = C , output fluctuation affects consumption

Question 24

What is precautionary saving for governments ?

Answer 24

• the acquisitions of a buffer of external assets “rainy day funds”

Question 25

Forms of precautionary saving :

Answer 25

1. Foreign reserves (central bank)

2. Sovereign wealth funds (state assets management companies )

Question 26

Formula for GDP in present time and no government :

Answer 26

PV (Q) = PV GNE

PV (Q) = PV C + PV I

Q: output

C : consumption

I: investment

Question 27

Exercise: (financial market and transfer to help offset a negative shock)

1. A college student needs to repeat a class, leading to a one time higher tuition

Answer 27

• The student can borrow to finance the increase in tuition and repay the loan over time

because education is viewed as CAPITAL INVESTMENT

(increasing productivity and potential earning )

Question 28

Exercise: (financial market and transfer to help offset a negative shock)

2. A small business owner in LA faces reduction in sales and damage to the property due to a earthquake

Answer 28

• To rebuild lost capital, the owner can borrow

- As her sales recover and production increase , he will be able to repay over time

Question 29

Exercise: (financial market and transfer to help offset a negative shock)

3. Bangladesh experiences widespread physical damage and job loss from the monsoon

Answer 29

• the gov can borrow to rebuild capital after the hurricane

- production increase , he will be able to repay over time