Econ 456 International Macroeconomics and Finance Spring 2016 Vancouver School of Economics, University of British Columbia Viktoria Hnatkovska...
Econ 456 International Macroeconomics and Finance Spring 2016 Vancouver School of Economics, University of British Columbia Viktoria Hnatkovska Problem Set 2.
Due at the beginning of class on Tuesday, Feb 9 2016 Capital controls. Consider a two-period small open economy with no investment and a single good studied in class. The representative household has preferences given by U(C 1; C 2) = 1 C 1 1 C 2 Households have free access to international …nancial markets, which allows them to borrow and lend at the world interest rate r 1 = r = 0 :1 : The representative household has initial net foreign wealth, (1 +r 0) B 0= 1 ;with r 0 = 0 :1 . The household also receives endowment of Q 1= 5 in period 1 and Q 2= 10 in period 2. Assume that (1 + r 1) = 1 :
1. Solve this model, that is …nd the equilibrium level of consumption, C 1 and C 2; trade balance, T B 1and T B 2; current account, C A 1and C A 2; and net international investment position at the end of period 1, B 1:
2. Suppose the country experiences a positive temporary output shock. In particular, Q 1 in- creases to 10, while Q 2remains unchanged. Calculate the e¤ects of this shock on consumption, savings, trade balance and current account.
3. Return to part (1). Suppose the government imposes capital controls in this economy. This implies that the net foreign wealth at the end of period 1 must be equal to zero, B 1 = 0 :
How will such policy a¤ect domestic interest rate, r 1? Calculate the equilibrium value of the domestic interest rate :Is it above, below or equal to the world interest rate, r ? Also …nd the equilibrium level of consumption, trade balance and current account in both period 1 and 2. Assume that remains unchanged at = 1 1+ r = 1 1 :1 = 0 :91 after capital controls are imposed :
4. Now redo question (2) for the case when capital controls are in place. How, if at all, capital controls a¤ect household’s behavior. Explain.
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