International Macroeconomics A

Spring 2010 - Prof. Ph. Bacchetta

Makeup Exam - Solutions
1. (10)
What is the impact of an increase in the rate of time preference on the current account?
benchmark case: ,(1 + r) = 1 ) C
1
= C
2
= C : at consumption path
increase in the rate of time preference: j " ) , # ) , < 1,(1 + r)
In this alternative scenario the consumer becomes more impatient and desires to
consume more immediately: C
1
C
2
. In an SOE the agent can lend and borrow,
therefore he can satisfy his impatience by borrowing C
1
1
1
in the rst period and
repaying (1 +r)(C
1
1
1
) in the second period. Thus, he will run a current account
decit in the rst period and match it by a current surplus in the second period in
order to satisfy intertemporal feasibility.
2. (10)
Switzerland has experienced a dramatic reduction in its current account surplus in 2008.
What explains this reduction?
The current account is dened by the following accounting relationship:
C
t
= A
t
+ 11
t
+ Tr
t
Considering the Swiss current account statistics, it appears that foreign trade has slightly
increased between 2007 and 2008 while services have remained roughly stable over that
same time frame. Labor income as well as current transfers have not been subject to
remarkable uctuations. The main driver of the reduction in the current account surplus
has been the sharp reversal in investment income (from +21.47% to 24.5%).
3. (10)
What is the consumption co-movement puzzle?
Basic setup: two countries, uncertainty and complete markets
C
1
+ C

1
= 1
1
+ 1

1
C
2
(a) + C

2
(a) = 1
2
(a) + 1

2
(a) 1
2
(a)
W
C
2
(/) + C

2
(/) = 1
2
(/) + 1

2
(/) 1
2
(/)
W
Consider the case where ,(1 + r) 6= 1 and assume a specic utility function: l(C) =
ln(C) ) l
0
(C) = 1,C
Solving for optimal consumption in state a we obtain
C
2
(a) =
(a),(1 + r)
j(a)
C
1
.
1
The same result holds for Foreign, thus
C
2
(a) + C

2
(a) =
(a),(1 + r)
j(a)
(C
1
+ C

1
).
By substituting into the equilibrium equation we get
1
2
(a)
W
=
(a),(1 + r)
j(a)
1
W
1
This implies
C
2
(a)
C
1
=
C

2
(a)
C

1
=
1
2
(a)
W
1
W
1
,
meaning that the per capita consumption growth rate should be perfectly correlated across
countries if markets are complete. More generally, with nancial globalization and risk-
sharing consumption co-movements should be higher than output co-movements.
However, empirical evidence shows the exact opposite: corr(j, j
w
) corr(c, c
w
).
The two most advocated explanations to the consumption co-movement puzzle are the fol-
lowing: rst, markets are far from being complete, and second, there exists a home-bias
puzzle" for equities.
4. (10)
Greece is on the brink of bankruptcy and there is some probability it will default on its
sovereign debt. There is actually a probability j of a 20% haircut on the debt. There is
a spread of 2000 basis points on this debt, while the risk-free corresponding interest rate
is 5%. Compute j. (Remarks: i) the solution can be found without calculator; ii) the
numbers used in this question are ctitious)
haircut (1 .) = 20%
spread on debt r
s
r
f
= 20%
r
f
= 5%
) compute the probability of default j
1 + r
f
= (1 j)(1 + r
s
+ j.(1 + r
s
)
= [1 j(1 .)](1 + r
s
)
Manipulating this expression, we nally obtain
j =
1
1 .
_
1
1 + r
f
1 + r
s
_
=
1
0.20
_
1
1.05
1.25
_
=
4
5
5. (25)
Consider the benchmark two-period model with consumption only. Assume that there is
uncertainty on future output so that
1
2
=
_
1
1
+ c with probability 1/2
1
1
c with probability 1/2
2
Also assume that , = 1,(1 + r) and that the utility function is
lnC
1
+ 1
1
[C
2
]
a) (15) What is the impact of - on the current account in this case?
max
C
1
;C
2
lnC
1
+ ,1
1
[C
2
]
subject to C
1
= 1
1
1
1
C
H
2
= 1
1
+ c + (1 + r)(1
1
C
1
)
C
L
2
= 1
1
c + (1 + r)(1
1
C
1
)
Set up the Lagrangian replacing 1
1
[C
2
]:
L = lnC
1
+ ,f0.5[1
1
+ c + (1 + r)(1
1
C
1
)] + 0.5[1
1
c + (1 + r)(1
1
C
1
)]g
The rst order condition w.r.t. C
1
reads
1
C
1
= ,[0.5(1 + r) + 0.5(1 + r)]
, C
1
= 1
Plugging this result in the current account identity, we obtain
C
1
= 1
1
= 1
1
C
1
= 1
1
1.
Considering the same setup without second period uncertainty delivers exactly the same
result for rst period consumption (C
1
= 1) and for the current account (C
1
= 1
1
1).
We can conclude that uncertainty, i.e. the presence of c, has absolutely no impact on
the current account. This can be rationalized by the fact that households have linear
preferences in period 2, meaning that they are risk neutral in period 2.
Now assume that the utility function is lnC
1
+ 1
1
[lnC
2
].
b) (10) What is the impact of - on the current account in this case?
max
C
1
;C
2
lnC
1
+ ,1
1
[lnC
2
]
subject to C
1
= 1
1
1
1
C
H
2
= 1
1
+ c + (1 + r)(1
1
C
1
)
C
L
2
= 1
1
c + (1 + r)(1
1
C
1
)
We again set up the Lagrangian replacing 1
1
[lnC
2
]:
L = lnC
1
+ ,f0.5 ln[1
1
+ c + (1 + r)(1
1
C
1
)] + 0.5 ln[1
1
c + (1 + r)(1
1
C
1
)]g
The rst order condition w.r.t. C
1
reads
1
C
1
= ,0.5
_
(1 + r)
1
1
+ c + (1 + r)(1
1
C
1
)
+
(1 + r)
1
1
c + (1 + r)(1
1
C
1
)
_
1
C
1
= 0.5
_
1
1
1
+ c + (1 + r)(1
1
C
1
)
+
1
1
1
c + (1 + r)(1
1
C
1
)
_
(1)
3
If we had no uncertainty, we know that the household would smooth consumption (C
1
=
C
2
) and that C
1
= 1
1
, thus implying C
1
= 0.
Let us consider whether the optimal consumption choice associated with the problem
without uncertainty represents a solution in the presence of uncertainty.
Replacing C
1
by 1
1
, we get
1
1
1
= 0.5
_
1
1
1
+ c + (1 + r)(1
1
1
1
)
+
1
1
1
c + (1 + r)(1
1
1
1
)
_
1
1
1
= 0.5
_
1
1
1
+ c
+
1
1
1
c
_
Further simplifying, we obtain
1 =
1
2
1
1
2
1
c
2
,
which is impossible given the requirement c 0. Herewith we have shown that if we set
C
1
= 1
1
, then the l.h.s. of (1) is less than its right side. Because the left side of (1) is
decreasing in C
1
whereas the right hand side is increasing in C
1
, it must be the case that
the optimal level of consumption in period 1 satises
C
1
< 1
1
.
From this condition it follows that
C
1
= 1
1
C
1
0.
Households use the current account as a vehicle to save to avoid having to cut consumption
in the bad state of the world. With convex marginal utility of consumption in period 2
the prospect of consuming 1
1
+ c or 1
1
c with equal probability increases the expected
marginal utility of consumption in that period.
6. (30)
Consider the following problem for a representative consumer who lives in a small open
economy that can borrow and lend at a constant real interest rate r. The representative
agent maximizes
l =
1

t=0
,
t
log(C
t
)
subject to the intratemporal constraint
1
t+1
= (1 + r)1
t
+ 1
t
C
t
and the transversality condition
lim
t!1
1
t+1
(1 + r)
t
= 0.
The variable 1
t
represents a constant, exogenous level of output. Assume that ,(1+r) = 1.
4
a) (10) First assume that agents in the economy expect 1
t
to remain constant at a level
1 . Derive the optimal consumption path and the optimal current account in this case.
L =
1

t=0
,
t
flog(C
t
) + `
t
[(1 + r)1
t
+ 1 C
t
1
t+1
]g
The rst order conditions read:
0L
0C
t
:
1
C
t
= `
t
0L
01
t+1
: `
t
= ,(1 + r)`
t+1
0L
0`
t
: 1
t+1
= (1 + r)1
t
+ 1
t
C
t
From the Euler equation C
t+1
= ,(1 + r)C
t
we obtain that consumption is at, i.e.
C
t+1
= C
t
= C.
In order to determine the optimal consumption path, we need to derive the intertem-
poral budget constraint:
1

t=0
_
1
1 + r
_
t
C
t
= (1 + r)1
t
+
1

t=0
_
1
1 + r
_
t
1.
With C
t+1
= C
t
= C, the above equation rewrites:
_
1 + r
r
_
C = (1 + r)1
t
+
_
1 + r
r
_
1
C = r1
t
+ 1
The optimal current account in this case is described by:
C
t
= 1
t+1
1
t
= 1 C + r1
t
= 1 (r1
t
+ 1 ) + r1
t
= 0.
b) (10) Now assume that the economy learns that at time 0 output will increase perma-
nently from 1 to 1 +c, with c 0. Derive the optimal consumption path and the optimal
current account in this case.
1 " permanently to 1 + c:
Consumption increases permanently by c:
C = r1
t
+ 1 + c.
The current account is still equal to zero because the increase in consumption is oset by
the increase in the endowment:
C
t
= 1
t+1
1
t
= 1 + c C + r1
t
= 1 + c (r1
t
+ 1 + c) + r1
t
= 0.
5
c) (10) Now assume that the economy learns that at time 0 output will increase temporarily,
i.e.
t
t
=
_
1 + c for t = 0
1 for t 0
with c 0. Derive the optimal consumption path and the optimal current account in this
case.
1 " temporarily to 1 + c:
To derive the optimal consumption path in this case we need to go back to the intertem-
poral budget constraint:
1

t=0
_
1
1 + r
_
t
C = (1 + r)1
t
+ 1 + c
. .
t=0
+
1

t=1
_
1
1 + r
_
t
1
. .
t>0
.
Simplifying:
_
1 + r
r
_
C = (1 + r)1
t
+ 1 + c +
_
1 + r
r
_
1 1
C = r1
t
+ 1 +
r
1 + r
c
) consumption increases by
r
1+r
c (= annuity value of the increase in output).
The behavior of the current account changes between t = 0 and t 0:
t = 0 : 1 " ) 1
1
= (1 + r)1
0
+ 1 + c C
= (1 + r)1
0
+ 1 + c
_
r1
t
+ 1 +
r
1 + r
c
_
= 1
0
+
c
1 + r
) C
0
= 1
1
1
0
=
c
1 + r
0
t = 1 : 1 = ) 1
2
= (1 + r)1
1
+ 1 + c C
= (1 + r)
_
1
0
+
c
1 + r
_
+ 1
_
r1
t
+ 1 +
r
1 + r
c
_
= 1
0
+
c
1 + r
= 1
1
) C
1
= 1
2
1
1
= 0
net foreign assets rise in period 1: the economy runs a CA surplus (intuition: save
some of the temporary output increase to consumer more in future periods)
from period 2 onward net foreign assets are constant, therefore C = 0
6
7. (25)
Consider the following problem of a representative consumer who lives in a small open
economy that can borrow and lend at an interest rate r. The consumers problem is
Max
C
1
;C
2
l = log C
1
+ , log C
2
subject to
C
1
= 1 1
1
G
1
C
2
= 1 + (1 + r)1
1
G
2
where 1 is a constant, exogenous level of output. The government sets consumption tax
rates t
1
and t
2
to balance its budget:
t
1
C
1
= G
1
and t
2
C
2
= G
2
.
Assume that ,(1 + r) = 1.
a) (10) Show that C
1
(1 + t
1
) = C
2
(1 + t
2
).
L = log C
1
+ , log C
2
+ `
_
\ (1 + t
1
)C
1

_
1 + t
2
1 + r
_
C
2
_
0L
0C
1
:
1
C
1
= `(1 + t
1
) (2)
0L
0C
2
:
,
C
2
= `
1 + t
2
1 + r
(3)
0L
0`
: (1 + t
1
)C
1
+
1 + t
2
1 + r
C
2
=
_
2 + r
1 + r
_
1 (4)
Combine (2) and (3) and obtain:
C
1
(1 + t
1
) = C
2
(1 + t
2
).
b) (8) Compute the value of C
1
and C
2
as a function of t
1
and t
2
.
To compute C
1
and C
2
use the intertemporal budget constraint and the result obtained
in (a):
(1 + t
1
)C
1
+
1 + t
2
1 + r
C
2
=
_
2 + r
1 + r
_
1
2 + r
1 + r
(1 + t
1
)C
1
=
_
2 + r
1 + r
_
1
C
1
=
1
1 + t
1
C
2
=
1
1 + t
2
c) (7) Characterize the behavior of the current account in periods 1 and 2.
C
1
= 1 C
1
G
1
= 1 (1 + t
1
)C
1
= 0
C
1
= 1 C
2
G
2
+ r1
1
= 1 (1 + t
2
)C
2
+ r1
1
= 0
7