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EFIM-M0098

International Economics and Finance

2022

Problem 1

Consider a a two period production economy similar to the one that was studied in class. Productivity is identical in the two periods and given by & =处=2. The production function is given by Q_t = + 1) for both time periods. The initial capital stock I_o is

given by e - 1, where e = 2.7183 is the base of natural logarithm (recall that ln(e) = 1). The preferences of households are given by the utility function

+堂

1 — a 1 — a

where 0 < < +oo. The initial household asset holdings are = e - 1 implying that the country has no initial foreign asset position (B_o = 0). Assume that this country is a small open economy and the international interest is given by r* = r₀ = 0.

1. Define precisely the equilibrium in this economy. (10 marks)

2. Derive the optimal level of investment in period 1. What does it imply for output

growth in this economy? (5 marks)

3. Now derive the Euler equation. How does the household's saving incentives change

with cr? Provide intuition. (5 marks)

4. Now show that, in this economy, Ci = | + ln(2). What is the current account in period

1 and how much is households' savings? Explain the sign of the current account and explain why the current account is not equal to household savings. You may want use the information that ln(2) = 0.6931. (5 marks)

5. Now assume the interest rate increases to r such that 0 < r < 1:

(a) First explain intuitively the three effects this interest rate change will have on the consumption allocation, on investment and on the current account. (6 marks)

(b) Explain the effect on the current account graphically using the investment and saving schedules (if needed make appropriate assumptions). (4 marks)

(c) Compute the change in the allocation and the current account in the case of

r = 1 when utility has the log form (a = 1). (5 marks)

(d) Can we boost investment by shutting down international trade in assets (borrowing and lending). Would it be welfare enhancing?      (3 marks)

6. Now, consider that our economy (call it economy i) is not a small open economy but a large open economy that is trading with another country (call it economy j). The two economies have identical preferences, production functions, and initial conditions (&,扁 and BR), however 4( is not necessarily equal to A\ . Also, the size of population in country i is N* and the size of country j is N^j.

(a) Define the equilibrium in the world economy consisting of these two countries.        (7 marks)

(b) Assume that = 2. Is the world interest rate less than 1? Is it bigger

than 0? Explain your answer, you may use results derived above. (3 marks)

(c) Explain, intuitively, the response of the equilibrium interest rate and the current accounts if period 1 productivity in country j drops. Would the investment and output drop be lower or higher compared to the case of a small open economy?      (6 marks)

(d) Provide graphical support for your intuition above. (5 marks)

(Total: 64 marks)

Problem 2

The war in Ukraine is affecting the economy in many countries. The prime minister of the UK, Boris Johnson has announced in March, that the sanctions against Russia will imply a 'painful' transition period for the UK economy as it has to find efficient ways to replace Russian energy imports. One way to interpret this is that the UK is facing a short-term (temporary) negative terms of trade shock as prices of import goods increased. In the following questions you need to think about what effect this shock will have on the current account and other economic indicators. In other words, you need to advise the Prime Minister regarding the expected effect of this shock on the UK economy.

\bu need to discuss all these issues using three modelling frameworks we studied in class.

1. Use the small open production economy framework and explain what type of eco

nomic response the Prime Minister should expect in terms of national debt, the current account, output and investment in this model. What would happen if the interest rates would suddenly rise? Support your answer with a figure. Would it change your answer if households and firms see future terms of trades going back to normal only in expectations, but with some risk around them? (18 marks)

2. Now assume that the UK is a large open economy and its main trading partner (ROW)

is affected in the opposite way (terms of trade improve) by the war. What would be the response to the war in the UK in this case? Can we expect the interest rate to stay the same? How does it depend on the relative size of the UK compared to the ROW? How would your answer change if the ROW is affected exactly the same way as the UK? Support your answer with appropriate figures. (12 marks)

3. Now assume instead that UK is small open TNT economy (that is endowed with both

tradable and non-tradable goods) studied in class and a war is just a temporary drop in the endowment of tradable goods as more expensive energy will lead to lower manufacturing output. What would be the effect of this on the current account, the relative price of tradables and on the real exchange rate? (6 marks)

(Total: 36 marks)