Question

Suppose a country has an investment opportunity that costs them 10 units of current consumption for an increase in 20 units of future consumption. The current and given real rate of interest is 10% (0.10). GDP, without the investment, in period 0 and period 1 is equal 120. The country has access to international capital markets.

a. Do the math and determine whether or not this country should borrow to take advantage of this investment opportunity. Explain. As is normally the case, the country prefers to completely smooth consumption.

b. Solve for the trade balance = current account in period 0 and the trade balance, NFIA, and the current account in period 1.

c. Explain the intuition as to why the CA and TB is different in period 1.

d. Draw a graph, completely labeled with indifference curves depicting clearly that Home is better off when they have access to international financial markets as compared to being a closed economy. In particular, label the indifference curve under a closed economy assumption assuming the country elected not to make the investment as ICclosed and the indifference curve under an open economy assumption (where the country did make the investment) as ICopen.

e. Suppose instead that this country was the US and had exorbitant privilege so that the (borrowing) interest rate was only 1% (.01) rather than 10% (.10) as above. Solve for the new level of consumption in both periods and compare the trade balance in period 0 when interest rates are 10% vs. the trade balance in period 0 with interest rates at 1%. Does the existence of exorbitant privilege result in this country borrowing more less in period 0?

Answer 1