Evaluate the effect of capital controls on welfare

Reference no: EM133666067

Problem

Consider a two-period model of a small open economy with a single good each period and no investment. Let preferences of the representative household be described by the utility function U(C1, C2) = SQRT(C1) + B SQRT(C2) The parameter β is known as the subjective discount factor. It measures the consumer's degree of impatience in the sense that the smaller is β , the higher is the weight the consumer assigns to present consumption relative to future consumption. Assume that β = 1/1.1. The representative household has initial net foreign wealth of (1 + r0)B∗ 0 = 1, with r0 = 0.1, and is endowed with Q1 = 5 units of goods in period 1 and Q2 = 10 units in period 2. The world interest rate paid on assets held from period 1 to period 2, r ∗ , equals 10% (i.e., r ∗ = 0.1) and there is free international capital mobility.

1. Calculate the equilibrium levels of C1, C2, T B1, CA1. (10 marks)

2. Suppose now that the government imposes capital controls that require that the country's net foreign asset position at the end of period 1 be non-negative (B∗ 1 ≥ 0). Compute the equilibrium value of the domestic interest rate r1, C1, C2, T B1, CA1. (10 marks)

3. Evaluate the effect of capital controls on welfare. Specifically, find the level of utility under capital controls and compare it to the level of utility obtained under free capital mobility.

Reference no: EM133666067

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