International Monetary Theory and Policy: U 1 U 2 U 1 U 2 E 1 E 2 E 1 E 2 U 1 U 2 E 1 E 2

Department of Economics Instructor: Martn Uribe
Columbia University Spring 2013

Economics W4505
International Monetary Theory and Policy
Homework 7
Due April 3 in class
1. A Two-Country Economy
Consider a two-period, two-country, endowment economy. Let one of the countries be the United
States and the other Europe. Households in the United States have preferences described by the
utility function
ln C
U
1
+ ln C
U
2
,
where C
U
1
and C
U
2
denote consumption of U.S. households in periods 1 and 2, respectively. Europeans
have identical preferences, given by
ln C
E
1
+ ln C
E
2
,
where C
E
1
and C
E
2
denote consumption of European households in periods 1 and 2, respectively. Let
Q
U
1
and Q
U
2
denote the U.S. endowments of goods in periods 1 and 2, respectively. Similarly, let Q
E
1
and Q
E
2
denote the European endowments of goods in periods 1 and 2, respectively. Assume further
that the endowments are nonstorable, that the U.S. and Europe are of equal size, and that there is free
capital mobility between the two economies. The United States starts period 1 with a zero net foreign
asset position carried over from period 0.
(a) Symmetric Equilibrium Suppose that Q
U
1
= Q
U
2
= Q
E
1
= Q
E
2
= 10. Calculate the equilibrium
world interest rate, and the current accounts in the United States and Europe in period 1.
(b) US-Originated Contraction # 1 Suppose that a contraction originates in the United States.
Specically, assume that Q
U
1
drops from 10 to 8. All other endowments (Q
U
2
, Q
E
1
, and Q
E
2
)
remain unchanged at 10. This contraction in output has two characteristics: First, it originates
in the United States (the European endowments are unchanged.) Second, it is temporary (the
U.S. endowment is expected to return to its normal value of 10 after one period). Calculate the
equilibrium interest rate and the two current accounts in period 1. Provide intuition.
(c) US-Originated Contraction # 2 Suppose now a second type of contraction in which the U.S.
endowment falls from 10 to 8 in the rst period but is expected to continue falling to 6 in the
second period (Q
U
1
= 8 and Q
U
2
= 6). The endowments in Europe remain unchanged at 10 each
period (Q
E
1
= Q
E
2
= 10). Like the one described in the previous item, this contraction originates
in the United States. However, it diers from the one described in the previous paragraph in the
fact that it displays a more protracted string of negative output growth rates. Calculate again
the equilibrium interest rate and the two current accounts in period 1. Point out dierences in
the eects of the two types of contraction and provide intuition.
(d) At the beginning of the great contraction of 2008, interest rates fell sharply around the world.
What does the model above say about peoples expectations around 2008 about the future path
of real activity.
2. An Small Open Economy With Distortionary Taxes
Consider a two-period economy populated by a large number of households with preferences described
by the utility function
ln C
1
+ ln C
2
,
where C
1
and C
2
denote consumption in periods 1 and 2, respectively, and = 1/1.1 is a subjective
discount factor. Households receive endowments Q
1
in period 1 and Q
2
in period 2, with Q
1
= Q
2
= 10
and can borrow or lend in international nancial markets at the interest rate r
= 0.1. The government

1
imposes taxes T
1
= T
L
+
1
C
1
in period 1 and T
2
=
2
C
2
in period 2 and consumes G
1
units of goods
in period 1 and G
2
units in period 2. Finally, households and the government start period 1 with no
assets or debts carried over from the past.
(a) Derive the intertemporal budget constraint of the household, the intertemporal budget constraint
of the government, and the intertemporal resource constraint of the economy as a whole.
(b) Derive the optimality condition that results from choosing C
1
and C
2
to maximize the households
utility function subject to its intertemporal budget constraint.
(c) Suppose G
1
= G
2
= 2 and
1
=
2
= 0.2. Find the equilibrium levels of consumption and the
trade balance in periods 1 and 2, and the equilibrium level of lump-sum taxes T
L
. Report the
primary and secondary scal decits in period 1.
(d) Continue to assume that G
1
= G
2
= 2. Suppose that the government implements a tax cut in
period 1 consisting in lowering the consumption tax rate from 20 to 10 percent. Suppose further
that lump-sum taxes, T
L
, are kept at the level found in the previous item. Find consumption,
the trade balance, the primary scal decit in period 1, and the consumption tax rate in period
2.
(e) Now answer the previous question assuming that the cut in consumption taxes in period 1 from 20
to 10 percent is nanced with an appropriate change in lump-sum taxes in the same period, while
the consumption tax rate in period 2 is kept constant at its initial level of 20 percent. Compare
your answer with the one for the previous item and provide intuition.
(f) Suppose that G
1
= 2, G
2
= 1, and T
L
= 0. Clearly, there are many possible equilibrium tax
schemes (
1
,
2
). Find the pair (
1
,
2
) that maximizes the households lifetime utility. Show your
derivation. Refer to your solution as the Ramsey optimal tax policy.
2

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Department of Economics Instructor: Martn Uribe

Columbia University Spring 2013

= 0.1. The government

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