Reference no: EM132812800

Consider a two-period small open endowment economy populated by a large number of households with preferences described by the lifetime utility function U(C1,C2)=lnC1 +βlnC2 where C1 and C2 denote consumption in periods 1 and 2, and β = 10/11 is the subjective discount factor. Suppose that households receive exogenous endowments of goods given by Q1 = Q2 = 10 in periods 1 and 2. Every household enters period 1 with some debt, de- noted by B0∗, inherited from the past. Let B0∗ be equal to -5. The interest rate on these liabilities, denoted r0, is 20%. Finally, suppose that the country enjoys free capital mobil- ity and that the world interest rate on assets held between periods 1 and 2, denoted r∗, is 10%.

a. Compute the equilibrium levels of consumption, trade balance, and current account in periods 1 and 2.

b. Assume now that the endowment in period 2 is expected to increase from 10 to 15. Calculate the effect of this anticipated output increase on consumption, trade balance, and current account in both periods. Compare your answer to that you gave for item a. and provide intuition.