Question 2 Consider a two-period economy that has at the beginning of period 1 a

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Question 2 Consider a two-period economy that has at the beginning of period 1 a net foreign asset position of -100. In period 1, the country runs a current account deficit of 10 percent of GDP, and GDP in both periods is 100. Assume the interest rate in periods 1 and 2 is 5 percent (a) Find the trade balance in period 1 (TB1), the current account balance in period 1 (CAi), and the country's net foreign asset position at the beginning of period 2 (Bj). Does the country have trade balance surplus or deficit? (b) Is the country living beyond its means? To answer this question ind the country's current account balance in period 2 and the associated trade balance in period 2. Is this value for the trade balance feasible? Hint: Keep in mind consumption has to be non-negative.] (c) Now assume that in period 1, the country runs instead a current account surplus of 10 percent of GDP. Find the country's net foreign asset position at the end of period 1, B. Is the country living beyond its means? If so, show why

Explanation / Answer

a) CA and TB are related as follows: CA1=TB1+rB1

B1=net foreign asst position at the beginning of period 1 and if B1<0,the country is a borrower and in this case, the CA deficit will exceed TB deficit.

CA1=100 * .10 = -10 and

Find TB1 by substituting the values in the above equation

Given B1= -100 and r=.5

So, TB1 = 5 (surplus)

If CA>0 then the country will reduce its debt obligations CA1 = B2-B1

We find that B2=-105

b) When there are only two periods,it means that B3 is either equal or greater than zero.

As, B2= -105 the current account in period 2 would be-

CA2=B3-B2 = 0-(-105) = 105

now,to find TB2=CA2-rB2 = 105-.05(-105) = 110.25

Since, 110.25>100.it is not feasible for the country to run a current account deficit of 10 percent in period 1.

c) Now, CA1= .1(100) = 10 and TB1= -5(compute the values by using the equation given in a.

and B2=B1+CA1 = -100+10 = -90

TB2=CA2-rB2 = 90-.10(-90) = 99

This is feasible and in this case,the country is not living beyond its means.

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