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Spring Semester 2021-22

ECN6620, International Money and Finance RESIT

International Money and Finance: Coursework

Consider a two-periods small open economy populated by households and firms with a single good produced each period.

The preferences of the representative household are described by the utility function

where  and  denote consumption in periods 1 and 2, respectively. In period 1, the household receives an endowment of Q₁ = 1. In period 2, the household receives profits, denoted by , from the firms it owns. In period 1, the household has access to financial markets where they can borrow or lend at the interest rate . The household has a zero initial asset holding position. Let the budget constraint in the first period be

,

where  is the household borrowing position in period 1.

Firms borrow in period 1 from the international financial market to invest in physical capital and to produce final goods in period 2. Denote by  the amount of debt taken by the firms in period 1. The production technology in period 2 is given by

,

where   and  denote output in period 2 and investment in period 1, respectively.

Both firms and households are subject to the same collateral constraint, with  denoting the value of the collateral. Suppose that  equals 10. Assume that the economy’s initial net foreign asset position is zero (b₀ = 0).

Question 1: Derive the general equilibrium in the private sector and provide intuition of your result. [max 650 words]

Question 2: Use the model to simulate the effects of an economic crisis and provide intuition of your result. [max 650 words]

Question 3: Explain what type of policy intervention could be used to mitigate the negative effects of the crisis and provide intuition of the effects of each of these on households and firms. [max 700 words]