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ECON 7520

SEMESTER 1, 2023

Tutorial 9

Problem 1 (A Model of A Sudden Stop)

Consider a two-period small open economy.  In period 1, the representative household receives endowments of 6 units of the tradable good and of 6 units of the nontradable good.  In period 2, the household receives 10 units of the tradable good and 6 units of the nontradable good (Q1(T)   =  6, Q2(T)   =  10, and Q1(N)   =  Q2(N)   =  6).  The household starts period 1 with no assets or liabilities (B0  = 0). The country enjoys free access to world inancial markets, where the prevailing interest rate is 15 percent (r*  = 0.15). Suppose that the household’s preferences are deined over consumption of tradable and nontradable goods in periods 1 and 2 and are described by the utility function

ln C1(T) + ln C1(N) + ln C2(T) + ln C2(N) ,

where Ct(T) and Ct(N) denote, respectively, consumption of tradables and of nontrad- ables in period t = 1, 2. Let p1  and p2 denote the relative prices of nontradables in terms of tradables in periods 1 and 2, respectively.

(a) Solve for the equilibrium values of C1(T) , C2(T) , C1(N) , C2(N) , p1 , and p2 .

(b) Calculate the equilibrium levels of the current account balance in periods 1 and 2 (CA1 and CA2 ).

(c) Assume that the domestic price level in period t = 1, 2, denoted Pt , is given by

Pt  = ^PtT PtN ,

where PtT  and PtN  denote the nominal prices of tradables and nontradables in period t  =  1, 2, respectively.  Similarly, suppose that the foreign price level is given by Pt*  = ^PtT* PtN* , where the superscript * denotes foreign variables. Foreign nominal prices are expressed in terms of foreign currency. Assume that PPP holds for tradable goods. Finally, suppose that the foreign relative price of nontradables in terms of tradables equals one in both periods. Compute the real exchange rates in periods 1 and 2 (e1 and e2 ).

(d) Let us sketch a scenario like the one that took place during the Argentine debt crisis of 2001 by assuming that because of fears that the country will not repay its debts in period 2, foreign lenders increase the interest rate from 15 percent to 100 percent (now r*  = 1.00). Compute the real exchange rate in periods 1 and 2 (e1 and e2 ) in this new situation.