TERM 1: CA & endowment economy

Question 1

small economy =

Answer 1

taken world IR & prices as given

Cannot influence them

Question 2

Choice variables for households

Answer 2

C1, B1* (bond holdings)

Question 3

Initial wealth inherited from past

Answer 3

(1+r0)B0*

Question 4

Period 1 BC

Answer 4

C1 + B1* - B0* = r0B0* + Q1

Question 5

Period 2 BC

Answer 5

C2 + B2* - B1* = r1B1* + Q2

Question 6

Transversatility condition

Answer 6

B2*=0

Question 7

Intertemporal BC

Answer 7

C1 + C2/(1+r1) = (1+r0)B0* + Q1 + Q2/(1+r1)

Question 8

Lifetime utility function

Answer 8

U = ln(C1) + ln(C2)

Question 9

4 properties of ICs

Answer 9

1. downwards sloping
2. monotonic
3. Ics do not cross
4. ICs convex to origin

Question 10

What’s does ICs convex to origin imply about preferences?

Answer 10

Diminishing MRS of C2 for C1

As we have more C1, only willing to give up a small amount of C2 for one extra unit C1.

Question 11

Where is the optimal graphically

Answer 11

Where intertemporal BC tangent to IC.

Question 12

Optimal C* depends on (4)

Answer 12

Preferences, endowments, initial wealth, IR

Question 13

Wealth (exogenous) =

Answer 13

W = (1+r0)B0* + Q1 + Q2/(1+r1)

Question 14

How do C2 and C1 relate from FOCs

Answer 14

C2* = (1+r1)C1*

Question 15

C2* as a fucntion of W and r1

Answer 15

C2* = 1/2 W(1+r1)

Question 16

C1* as a fucntion of W

Answer 16

C1* = 1/2 W

Question 17

C1* as a fucntion of r0, B0*, Q1, Q2, r1

Answer 17

C1* = 1/2[(1+r0)B0* + Q1 + Q2/(1+r1)]

Question 18

C1* is increasing in

Answer 18

Q1, Q2, (1+r0)B0*

Question 19

C1* is decreasing in

Answer 19

r1

Question 20

TB1 is equal to

Answer 20

TB1 = Q1 - C1

difference between output and consumption

Question 21

IF C1 > Q1

Answer 21

Must import from ROW therefore TB1 < 0

Question 22

IF C1 < Q1

Answer 22

Export to ROW therefore TB1 > 0

Question 23

CA1 =

Answer 23

CA1 = r0B0* + TB1

Question 24

TB1* formula

Answer 24

1/2[-(1+r0)B0* + Q1 - Q2/(1+r1)]

Question 25

CA1* formula

Answer 25

1/2[-(1-r0)B0* + Q1 - Q2/(1+r1)]

Question 26

What does free K mobility mean? Implicationfor IR too

Answer 26

households can borrow and lend in international financial market. r1 = r* i.e. domestic IR = world IR

Question 27

If r1 > r* what happens?

Answer 27

investors borrow in international markets, lend in domestic markets. Excess supply in dom = r1 falls. Excess demand in inter. = r* rises. Arbitrage opporuntities disappear.

Question 28

A temporary output shock

Answer 28

Q1 rises, Q2 stays the same.

Question 29

How does a temporary +VE output shock affect CA1*? Explain.

Answer 29

Housholds know shock is temporary, want to smooth consumption, so increase C1 but also increase S1 to save for period 2. Increase in Q1 > increase in C1. Therefore TB1 improves, CA1 improves as more saving.

Question 30

Formula for effect of permanent output shock on CA1*. Explain.

Answer 30

change CA1* = 1/2 r*/(1+r*) change in Q1. | Smaller change in CA1 as do not need to increase saving to smooth consumption as Q2 increases too.

Question 31

Difference between impact of temporary and permanent shocks

Answer 31

Finance tempoary shocks by running CA surpluses/deficits to smooth consumption. Adjust to permanent shocks by changing consumption in the LR to keep CA stable.

Question 32

What have we assumed so far avout the goods?

Answer 32

That there's just one good which is consumed, imprted and exported.

Question 33

Terms of trade = + formula

Answer 33

The relative price of exportable goods in terms of importable goods. TT = Px/Pm

Question 34

Now we assume bonds are denominated specifically in terms of...

Answer 34

Importable goods Pm

Question 35

Period 1 and 2 BC including TT

Answer 35

C1 + B1* - B0* = r0B0* + TT1 Q1 | C2 + B2* - B1* = r1B1* + TT2 Q2

Question 36

Intertemporal BC including TT

Answer 36

C1 + C2/(1+r1) = (1+r0)B0* + TT1Q1 + TT2Q2 /(1+r1)

Question 37

How are TT determined in a small open economy?

Answer 37

They are GIVEN

Question 38

A TT shock is just like an...

Answer 38

endowment shock

Question 39

temporary TT shock effect on CA

Answer 39

large effect on TB & CA to smooth consumption

Question 40

permanent TT shock on CA

Answer 40

small effecr on TB & CA

Question 41

What about the shock matters to determine impact on CA?

Answer 41

whether agents THINK the shock is permanent/temporary, doesnt actually matter whether it was ex-post

Question 42

2 effects higher IR can have on C1 and CA1

Answer 42

1. SE - higher r* = C2 more attractive relative to C1 = C1 falls, S1 rises = CA1 improves 2. WE - higher r* = makes debtors poorer, lenders richer. C1 falls for debtors = CA improves; C1 rises for lenders. = CA worsens

Question 43

Which effect dominates? Under what condition?

Answer 43

SE > IE. When utility preferences are log.

Question 44

Explain effect of rise in r* graphically for debtor

Answer 44

Steeper BC = pivots around endowment point Original equilibrium not feasible C1 falls and C2 rises TB1 & CA1 improve

Question 45

Rationale for K controls

Answer 45

To curb CA deficits which arguably risk future crises and reduce C2

Question 46

Strong form of K controls requires:

Answer 46

B1* >=0 | Can lend but cannot borrow

Question 47

Impact of K controls on C1 and C2 - new equilibrium

Answer 47

C1 falls so C1=Q1 C2 rises so C2=Q2 New equi at endowment point

Question 48

What has to happen to domestic IR to make the endowment point the new optimum after K controls?

Answer 48

Increase domestic IR r1 above r* world IR | Encourages saving so now happy not to borrow = no longer a debtor.

Question 49

formula for r1 under K controls scenario

Answer 49

C2=(1+r1)C1 C2 = Q2 and C1 = Q1 therefore: r1 = (Q2 / Q1) - 1

Question 50

How r1 related to Q2 and Q1

Answer 50

The lower Q1 is relative to Q2, the more households want to borrow against future income. To make them not do this, r1 has to be even higher.