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.