Question 1. Take a one-good small economy where households receive endowment inc

Question

Question 1. Take a one-good small economy where households receive endowment income Y per period, and pay taxes to T the government. The tax function is comprised of two parts. There is a constant proportional income tax t0 and a transfer which is a fraction of the stock of foreign exchange reserves F. Households have no access to capital markets and simply consume their disposable income.

The government can accumulate foreign exchange reserves which receive interest r per instant (time is continuous). The governments budget constraint is thus

the income account, the current account, and the financial account.

b) Describe the dynamics of the stock of international reserves. Is this equation stable? Under what conditions will the stock of reserves converge to a steady state? Assuming stability, solve for this steady state, and explain.

c) Describe the dynamics of each account in the balance of payments following an unexpected permanent increase in Y .

Explanation / Answer

a. First of all we need to understand what is balance of payment

BOP is the International concept. It is the exchange that takes place between the residence of the country and the foreign country or rest lf the world.

-Trade balance- Its the difference between the exports and inports of the country.

Formula for Trade balance is =Export-Import.

INCOME ACCOUNT-It shows the debit and credit account of a business. Basically it shows the income earned in the business record during the financial year.

Debit is the amount that is reduced whereas credit is the account that is added.

CURRENT ACCOUNT- It is the account with the commercial banks or financial institutions where money can be withdrawn without any notice. It is mainly used by those who have regular transaction through cash or cheques.

FOR EXAMPLE - BUSINESSMAN .

FINANCIAL ACCOUNT- It is a kind of business record maintained of the financial transactions that took place during the financial year. Its a summary of the debit and credit of business and helps in analyzing the do and don't in business.

(b) International Reserves are linked with the gross inflow of money and gross outflow of money. The main authority is held with the CENTRAL GOVERNMENT. Monetary authority can purchase national currency in international capital market.

The condition of reserves converge to a steady state with the following factors that are as follows-

1. Standard of open market economy.

2. Rate of interest set by the financial institution.

3.Reserve acculmulation process.

4. Foreign exchange market.

5.Government role in making of monetary policies.

In this case the source of income is only from the disposable income for which the household have no access to huge income process. And the Government has more sources to earn from the taxes of international market.

In this case the economy is not in a stable condition due to lack of access of capital market income.

(c) The dynamics of each account in balance of payments are-

trade balance has the only source earned from the disposable income irrespective of the taxes imposed by the government.

Income of government could be earned in foreign currency case already the case of study is of a small economy and their source also exist i small economy. The government can gain even adding the interest to extend.

If we talk about foreign exchange then the concept of BRETTONWOOD plays a very important role in an economy.

In this case the government gains a interest in time t which is continuous.

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