International Finance - Assignment 1

Richard Walker, Northwestern University

Winter 2017

There are 65 points available. Write your answers in the spaces provided.

1
Consider the 2-period model of intertemporal trade from class, with endogenous output. Everything is as
before, except now there are more than two countries. There are n western countries and in addition China
and India, making n + 2 countries in total. Each has an Intertemporal Production Possibility Frontier (IPPF)
that gives the different combinations of banana output that it can choose to have in periods 1 and 2. These
are pictured below. Each western country has IPPFW , while the IPPFs of China and India coincide. Note
that 1 > 1 and 2 > 2 .

Y2

2 IPPFCH , IPPFIN

IPPFW

Y1
0 1 1

In words: if China or India were to dedicate all of its efforts to current banana production, it would have 1
bananas today and none tomorrow; if it were to dedicate all of its efforts to future banana production, it
would have no bananas today and 2 bananas tomorrow. For a western country the situation is different: each
could have 1 today and none tomorrow, or alternatively none today and 2 tomorrow. Of course, each
country could also choose an intermediate (Y1 , Y2 ) combination anywhere on its individual IP P F .

As in class, each country takes the world interest rate r as given, and first chooses its optimal production
stream (Y1 , Y2 ) in order to maximise the present value thereof; it then borrows or lends in the international
capital markets to finance its preferred intertemporal consumption choice (c1 , c2 ). In the latter stage each
maximises a logarithmic utility function:
c2
Max ln [c1 ] + ln [c2 ] s.t c1 + E
1+r
Y
where E = Y1 + 1+r2
. Each country has the same utility function, i.e. the same discount factor . The
solutions to the above problem are, for each country:
E
c1 =
1+
(1 + r) E
c2 =
1+

2
(i) What is each countrys optimal production stream in general equilibrium? Justify your answer. (5 points)

Answer:

3
(ii) Given these production choices, solve for the equilibrium world interest rate r using the solution (given
above) for optimal first-period consumption along with the first-period aggregate resource constraint (which
here involves n + 1 n + 2 countries). Your expression for r should contain some or all of the basic
parameters of the model. What restriction on these basic parameters must hold in order for an equilibrium to
exist? Show your work. (10 points)

[Note: by basic parameters of the model I mean the set {1 , 2 , 1 , 2 , , n}.]

Answer:

4
...

5
(iii) Find a condition involving some or all of the models basic parameters that ensures China and India are
each better off (in terms of lifetime utility) than an individual western country. Explain the condition as best
you can.(12 points)

Answer:

6
...

7
(iv) Draw the general equilibrium of the economy below, for the case of n = 2. Indicate the optimal
production points, the resulting budget constraints, the optimal consumption points, the indifference curves
attained and each countrys borrowing/lending. (10 points)

Answer:

Y2

Y1
0 1 1

8
...

9
For parts (v)-(vii) you should assume that, due to domestic capital market imperfections, China
is unable to borrow on the world banana market. However, it is able to lend in the first period,
while India and the western countries can both borrow and lend as before.

(v) Draw on the diagram below the intertemporal budget constraint China would face for some arbitrary
interest rate and some arbitrary interior production choice (by interior I mean a point on the IPPF that is
not a corner solution). Be sure to indicate clearly the budget set, i.e. the set of intertemporal consumption
bundles China can choose. (5 points)

Answer:

Y2

Y1
0 1

10
(vi) What does the general equilibrium of this global economy look like now China is credit-constrained?
Draw it on the diagram below. Indicate the optimal production points, the resulting budget constraints, the
optimal consumption points, the indifference curves attained and each countrys borrowing/lending. Make
sure to explain your answer. [Hint: algebra wont help you figure out what the general equilibrium looks like;
youll have to think graphically/intuitively.] (10 points)

Answer:

Y2

Y1
0 1 1

11
...

12
(vii) What are the welfare effects of Chinas borrowing constraint? In other words, are China, India and the n
western countries made better or worse off by China being unable to borrow? Explain your answer as best you
can (words, pictures, algebra). (13 points)

Answer:

13
...

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