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    Section 1 With Answers

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    (i) The American trade balance in period 1 is written in terms of the output variables Y1A, Y2A, the discount factor δ, and interest rate r. (ii) The equilibrium world interest rate r* is solved for in terms of δ and the output variables, and is equal to the ratio of global output in period 1 to period 2. (iii) Substituting the answer from (ii), the American trade balance is written solely in terms of the output variables and δ. (iv) For America to run a period 1 trade deficit, its growth rate must exceed the global growth rate of banana production, which necessarily means its growth must

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    Section 1 With Answers

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    (i) The American trade balance in period 1 is written in terms of the output variables Y1A, Y2A, the discount factor δ, and interest rate r. (ii) The equilibrium world interest rate r* is solved for in terms of δ and the output variables, and is equal to the ratio of global output in period 1 to period 2. (iii) Substituting the answer from (ii), the American trade balance is written solely in terms of the output variables and δ. (iv) For America to run a period 1 trade deficit, its growth rate must exceed the global growth rate of banana production, which necessarily means its growth must

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    (i) The American trade balance in period 1 is written in terms of the output variables Y1A, Y2A, the discount factor δ, and interest rate r. (ii) The equilibrium world interest rate r* is solved for in terms of δ and the output variables, and is equal to the ratio of global output in period 1 to period 2. (iii) Substituting the answer from (ii), the American trade balance is written solely in terms of the output variables and δ. (iv) For America to run a period 1 trade deficit, its growth rate must exceed the global growth rate of banana production, which necessarily means its growth must

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    50 views2 pages

    Section 1 With Answers

    Uploaded by

    miggawee88
    (i) The American trade balance in period 1 is written in terms of the output variables Y1A, Y2A, the discount factor δ, and interest rate r. (ii) The equilibrium world interest rate r* is solved for in terms of δ and the output variables, and is equal to the ratio of global output in period 1 to period 2. (iii) Substituting the answer from (ii), the American trade balance is written solely in terms of the output variables and δ. (iv) For America to run a period 1 trade deficit, its growth rate must exceed the global growth rate of banana production, which necessarily means its growth must

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    of 2

    International Finance - Section 1 with answers

    Richard Walker, Northwestern University

    1. Consider the model of intertemporal trade developed in lectures, i.e. the two-country, two-period model
    with logarithmic utility. Assume that the output streams of America and China are exogenous: America
    produces Y1A of bananas in period 1 and Y2A in period 2, while China produces Y1C in period 1 and Y2C in
    period 2. Note that, unlike in lectures, we are not placing any numerical values on the output variables.

    (i) Using the solutions to the individual consumption decisions, write the period-1 American trade balance in
    terms of Y1A , Y2A , the intertemporal discount factor and the interest rate r.

    Solving Americas utility maximisation problem (subject to its intertemporal budget


    constraint) yields:
    1
    cA
    1 = EA
    1+
    Y2A
     
    1 A
    = Y1 +
    1+ 1+r

    Americas trade balance is simply the difference between its output and its consumption in
    period 1:

    1 Y2A
    Y1A cA
    1 = Y1A
    1+ 1+1+r

    (ii) Solve for the equilibrium world interest rate r in terms of and the output variables Y1A , Y2A , Y1C and
    Y2C .

    Using the period-1 aggregate resource constraint, equating global banana supply to Chinese
    and American demand:

    Y1A + Y1C = cA C
    1 + c1
    Y A + Y2C
     
    1
    = Y1A + Y1C + 2
    1+ 1+r
    Y2A + Y2C
    (1 + r) =
    Y1A + Y1C

    with r implicitly defined by the last equation, so that (1 + r) is equal to the ratio of global
    banana output in period 1 to global output in period 2. Put another way, (1 + r) = 1 + g, where
    g is the global growth rate of output.

    1
    (iii) Use the answer to (ii) to write the American trade balance in terms of the output variables and .

    Y1A cA A C
    1 = Y1 c1
    YA
     
    1
    = Y1A Y1A + 2
    1+ 1+r
    Y + Y1C
    A
     

    = Y1A Y2A 1A
    1+ Y2 + Y2C

    (iv) What must be true of the dynamic output streams of America and China if the former is to be running a
    period-1 trade deficit?

    An American trade deficit is where Y1A < cA


    1 ; using previous answer, this is the case if:

    Y2A Y A + Y2C
    A
    > 2A
    Y1 Y1 + Y1C

    i.e. if the American growth rate exceeds the global growth of rate of banana production. If this
    is to be the case, the American growth must necessarily exceed the Chinese growth rate.

    So, an important result: at least in our simple model (with logarithmic utility, exogenous
    output endowments, etc), America will run a trade deficit with China if it expects to grow more
    quickly, regardless of the absolute levels of the respective outputs.

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