International Finance - Section 2 with answers

Richard Walker, Northwestern University

Consider the 2-country, 2-period model of intertemporal trade from class, with endogenous output levels. As
in class, each country takes the world interest rate r as given, and first chooses its stream of banana
production (Y1 , Y2 ) in order to maximise the present value thereof; it then borrows and/or lends in the
international capital markets to finance its preferred intertemporal consumption choice (c1 , c2 ). In the latter
stage each maximises the usual logarithmic utility function:

c2
Max ln [c1 ] + ln [c2 ] s.t c1 + E
1+r

Y2
where E = Y1 + 1+r . Each country has the same utility function, i.e. the same discount factor .

The IPPFs are implicitly described as follows. In each period a countrys overall productive capacity P is a
function of physical capital K:

P1 = F (K1 ) (1)
P2 = F (K2 ) (2)

where subscripts refer to the time period. So the USs period-1 productive capacity is equal to F (K1us ), where
K1us is the USs period-1 stock of physical capital; its period-2 productive capacity is the same function F (.)
of period-2 physical capital. The productive capacities of China in the two periods are described by exactly
the same function F (.), only with the physical capital stocks potentially differing from those of the US.

F
Some properties of the function F (K) are that: K > 0, so increased K leads to increased production;
2 F
K 2 < 0, so the marginal productivity of physical capital falls as K rises.

Each country takes its period-1 capital stock as given; it is inherited from history. However, for each country
the period-2 capital stock K2 is a choice variable, as now described. In the first period a country can allocate
its productive capacity P1 between output of consumption goods Y1 (bananas) and output of investment
goods I1 (banana factories). In the second period there is no point in producing investment goods, and so
each countrys entire productive capacity is devoted to the output of bananas. This is summarised by the
following equations:

1
 P1 = I1 + Y1 (3)
P2 = Y2 (4)

The benefit from allocating period-1 resources to investment rather than consumption goods is that this
increases the period-2 capital stock and thus period-2 banana output:

K2 = K1 + I1 (5)

Note period-1 investment must be nonnegative: I1 0.

(i) Use equations (1)-(5) to obtain the function describing the IPPF of each country. That is, write period-2
banana output Y2 in terms of period-1 banana output Y1 and the exogenous variable K1 . [Hint: this is simple
substitution; start with (4).]

Y2 = P2 = F (K2 )
= F (K1 + I1 )
= F (K1 + F (K1 ) Y1 ) = G (Y1 )

Explanation of last lines notation: since K1 is exogenous, we can write F (K1 + F (K1 ) Y1 ) as a
function G (.) of Y1 , where G (x) = F (K1 + F (K1 ) x).

(ii) Derive the first-order condition for optimal production (i.e. the equation for the tangency condition).

The problem:
Y2
Max Y1 + s.t Y2 G (Y1 )
1+r
reduces to the following once we recognise that the constraint will hold with equality:
G (Y1 )
Max Y1 +
1+r
This gives us the following first- and second-order conditions:
0
G (Y1 )
1+ =0 (foc)
1+r
00
G (Y1 )
<0 (soc)
1+r
Lets rewrite the first-order condition, exploiting what we know about the function G (.):
0 0
(1 + r) = G (Y1 ) = F (K1 + F (K1 ) Y1 ) (foc)

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using the chain rule. If you proceed similarly with the second-order condition you can see that
00 00
G (Y1 ) = F (K1 + F (K1 ) Y1 ), and so the condition is satisfied thanks to our initial assumption
00
that F (.) < 0.

(iii) Draw the two countries IPPFs under the assumption that K1us > K1ch , so that the US inherits a larger
physical capital stock from history. Make sure to label the intercepts and to justify the shape of the two
IPPFs.

First, the intercepts. The maximal possible value of Y1 is that which occurs if there is no
period-1 investment, i.e. Y1 = P1 = F (K1 ). Note that if this is the case and I1 = 0, we have
Y2 = G (F (K1 )) = F (K1 ). This is unsurprising, since with no period-1 investment K2 = K1 . So,
the most southeasterly point on a countrys IPPF will be where both Y1 and Y2 equal F (K1 ), i.e.
not on the horizontal axis but instead on a 45 line from the origin. The US IPPF will be
further out along this 45 line, since it inherits a larger K1 .

The maximal possible value of Y2 occurs when all of the countrys period-1 productive capacity
is allocated toward investment, so that I1 = F (K1 ). So, the most northwesterly IPPF point is on
the vertical axis, with Y1 = 0 and Y2 = G (0) = F (K1 + F (K1 )). Again, the US IPPF will have a
higher intercept than the Chinese one.
0 00
Finally, we know from above that G (Y1 ) < 0 and G (Y1 ) < 0, so each IPPF has the regular shape
between the above points (i.e. its concave to the origin).

(iv) Maintaining the assumption that K1us > K1ch , prove that China will run a trade deficit in general
equilibrium. You may appeal to the result that the faster-growing country (in terms of banana output) will
run a trade deficit.

Lets look at that first-order condition from part (ii) again:

0 0
(1 + r) = G (Y1 ) = F (K1 + F (K1 ) Y1 ) (foc)

Once we remember that (K1 + F (K1 ) Y1 ) is all just equal to K2 , this condition becomes very
straightforward:
0
(1 + r) = F (K2 ) (foc)

The economic intuition behind the first-order condition (foc) is important here. Im going to
outline this now, from both partial and general equilibrium perspectives.

First, from the point of view of an individual country that takes the interest rate r as given,
0
(foc) is saying that the marginal productivity of capital F (K2 ) (or M P K, or in plain English
the return to building another factory) must equal (1 + r). This makes sense. Forgetting
consumption issues completely for a moment and focusing solely on banana output, consider a
country that wants to give up a single banana today and get some more bananas tomorrow. It
can do this in two distinct ways, the most obvious being by exploiting its IPPF. Producing one
banana fewer in period 1 frees up some productive capacity that can then be allocated to

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increased investment (i.e. more banana factories); essentially the country trades the period-1
0
banana for another unit of period-2 capital stock, yielding an amount F (K2 ) of additional
period-2 bananas. The second way to make the intertemporal output trade is by exploiting the
international banana market, which you can think of as just another available technology like
the IPPF; the market is a machine for turning period-1 bananas into period-2 bananas. The
country could keep its IPPF location unchanged and just lend out a period-1 banana, getting
another (1 + r) period-2 bananas in return. In equilibrium the return on each strategy (using
0
the IPPF or simply lending a banana) must be the same, i.e. we should expect F (K2 ) = (1 + r).
If this werent true the country would shift to the strategy with the higher return; such a shift
would involve either more or less physical investment (banana-factory-building), reducing or
increasing the countrys M P K until (foc) holds. So, one way to view (foc) is as reflecting
arbitrage by a single country across two different intertemporal output-trading strategies.

Now for some general equilibrium intuition. Obviously the preceding paragraph applies to both
countries, so if they face the same interest rate we should expect them to have the same M P K
in equilibrium. Now remember that the interest rate is endogenous. Essentially what (1 + r), a
relative price, does is to adjust to make sure that all the available gains from trade between the
two countries are exhausted. This is only the case where the countries have the same M P K. If
the M P Ks differed across the two countries, then there would be scope for a Pareto
improvement as follows. The high-K2 /low-M P K country could cut back on period-1 physical
investment and instead produce more period-1 bananas; it could send these period-1 bananas to
the low-K2 /high-M P K country, in return for some amount of period-2 bananas tomorrow; the
latter country would be able to do this (without being any worse off ) by eating the period-1
bananas its just been given, cutting back on its own period-1 banana production by the same
amount, and using the freed-up productive capacity to instead build more banana factories and
sending the resulting increase in output of period-2 bananas to the low-M P K country; in effect
the low-M P K country would outsource its factory-building to the high-M P K one, thereby
exploiting the latters greater return to physical capital. Given that there will always room for
such a Pareto improvement when M P Ks differ, the only Pareto-efficient point is where the
M P Ks are equalised, and this is what the (endogenous) interest rate ensures via (foc).1

So far weve only talked about output, not consumption. How does the result that the two
countries should have the same equilibrium M P K help us understand who ends up running the
trade deficit? Well, since they share the production function F (.), and since K is the only
0
argument of that function, equalising F (K2 ) obviously implies equalising K2 , which in turn
means they have the same Y2 = F (K2 ) in general equilibrium. In other words China builds so
many factories in period 1 that it catches up with America in period 2, in terms of both capital
stock and banana output. Or, put another way, the two countries chosen optimal production
points must lie on a horizontal line from the vertical axis. A more direct (but less intuitive)
way to see this is to observe that the IPPFs have identical slopes along any horizontal line, as is
easily checked, and so the two countries optimal tangency points in any general equilibrium
must lie on one such line.

How does this fact help us? Well, if the two countries have the same period-2 output then the
US must have higher period-1 output, which in turn means China is growing more quickly.
Appealing to the result from section 1 then delivers the result were after, namely that China
should run a trade deficit.

1 This is the magic of markets and prices; under certain assumptions they lead to Pareto-efficient outcomes.

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NOTE! The fact that we should expect M P Ks to be equalised across countries is theoretically
fairly robust (as long as we have perfect international mobility, all countries face same interest
rates, etc). However, the consequent implication in the model here, namely that the levels of
period-2 capital stocks K2 should also be identical, is not. Here, K-equalisation follows from
M P K-equalisation because K is the only factor in the production function F (.). If we expanded
things slightly and allowed (say) human capital to appear in the production function, then it
would be perfectly possibly for equilibrium levels of K2 to vary across countries. The
implications for relative growth rates and thus for trade/capital flows would be unclear. For
example, M P K equalisation might still imply that Chinas stock of K grows more quickly in
equilibrium (as above), but if human capital were growing much more quickly in the US it
would be possible for the US to be the faster-growing country, and thus the one expected to
run the trade deficit.