Problem set 1

ECON 4330

Part 1
We are looking at an open economy that exists for two periods. Output in each
period Y1 and Y2 respectively, is given exogenously. A representative consumer
maximizes life-time utility

U = u(C1 ) + βu(C2 )

where C1 and C2 are consumption in the two periods and β is a subjective

discount factor, 0 < β < 1.The country can borrow and lend in world markets
at a given real interest rate, r. The initial asset is zero. Hence, the budget
constraint can be written
C2 Y2
C1 + = Y1 +
1+r 1+r
1. Derive the first order condition for optimal consumption and interpret it.

solution Using the method of substitution (if you want, use Lagrange
method). Solve the budget constraint for C2

C2 = Y1 (1 + r) + Y2 − (1 + r)C1 (1)

and substitute the constraint into the objective function

U = u(C1 ) + βu(Y1 (1 + r) + Y2 − (1 + r)C1 ) (2)

Maximize the objective function wrt C1 . The FOC is

u0 (C1 ) − βu0 (C2 )(1 + r) = 0

⇔
0 1
u (C1 ) = βu0 (C2 )
1+r
⇔
βu0 (C2 ) 1
= (3)
u0 (C1 ) 1+r

The left-hand side of the last expression is the marginal rate of substi-
tuion (M RS) between consumption in period 1 and 2, i.e. how much

1
 C1 you are willing to trade for one more unit C2 (given constant util-
ity). The right hand side is the relative price of consumption in period
2, i.e. how much C1 you have to give up to get one more unit C2 .
1
In optimum M RS(C1 , C2 )=relative price. If M RS > 1+r you can
1
increase utility by trading C1 for C2 and vice versa if M RS < 1+r .

2. Derive the welfare effects of an increase in r, i.e dU/dr. Provide intuition.

(use the envelope condition)

solution Substituting 1 into 3 , gives us one equataion to the determine

optimal period 1 consumption C1∗ as function of the exogenous vari-
ables C1∗ (r, Y1 , Y2 ). Optimal period two consumption follows from eq.
1: C2∗ (r, Y1 , Y2 ) = (1 + r)Y1 + Y2 − (1 + r)C1∗ (r, Y1 , Y2 ). Substituting
this into the objective function gives the indirect utility function, i.e.
maximal utility as a function of exogenous variables

U ∗ (r, Y1 , Y2 ) = u(C1∗ (r, Y1 , Y2 ))+βu(Y1 (1+r)+Y2 −(1+r)C1∗ (r, Y1 , Y2 ))

To see how welfare is affected by an increase in the interest rate we

derive
∗
∂C1∗
 
∗ 0 ∗ ∂C1 0 ∗ ∗
∂U /∂r = u (C1 ) + βu (C2 ) Y1 − C1 − (1 + r)
∂r ∂r
∗
∂C1 0 ∗
= βu0 (C2∗ ) (Y1 − C1∗ ) + [u (C1 ) − (1 + r)βu0 (C2∗ )]
∂r
In optimum the FOC holds, u0 (C1∗ ) − (1 + r)βu0 (C2∗ ) = 0, and we are
left with
∂U ∗ /∂r = βu0 (C2∗ ) (Y1 − C1∗ )
We the see that the sign of the welfare effect depends on the sign
of (Y1 − C1∗ ), that is whether the country is a borrower or a lender
in the first period. If the country is a lender in the first period
Y1 > C1∗ , welfare improves when the interest rate increase. Note
that an increase in the interest rate is the same as a reduction in the
relative price of period 2 consumption. If the country is a lender, it
exports period 1 consumption and imports period 2 consumption. A
reduction in the interest rate therefore improves the country’s terms
of trade (the price of imports)/(price of exports). It now gets more
for what it exports and pay less for what it imports, and the country
is better off.

3. Assume CRRA utility

1
C 1− σ
u(C) =
1 − σ1
Find an expression for date 1 consumption and current account as func-
tions of exogenous variables (Y1 , Y2 , r).

2
solution Use:
C2 = (β(1 + r))σ C1
and the budget constraint
C2 Y2
C1 + = Y1 +
1+r 1+r
σ σ−1 Y2
C1 (1 + β (1 + r) ) = Y1 +
1+r
1 Y2
C1 = (Y1 + )
(1 + β σ (1 + r)σ−1 ) 1+r

4. Assume Y2 = 0

(a) Derive ∂C1 /∂r and find condition that makes sure the current account
is improving when the world interest rate goes up.
solution Current account in a model without investment CA1 = S1 =
Y1 − C1 . To find the consumption response to r use the expression
from the last problem with Y2 = 0
and the budget constraint
1
C1 = Y1
(1 + β σ (1 + r)σ−1 )
take the derivative wrt r to get
∂C1 (σ − 1) β σ (1 + r)σ−2
=− Y1
∂r (1 + β σ (1 + r)σ−1 )2
If σ > 1 the date 1 consumption goes down and saving increases.
Intuition: High σ implies that the substitution effect is large!
(b) Describe how C1 responds to changes in r in terms of substitution
and income effects.
1
solution Let p2 = 1+r . An increase in r reduces the price of C2 . The
agent therefore substitutes towards C2 , the good that is now rela-
tively cheaper. But as p2 goes down the agent pays less for period
2 consumption, which increases real income. The increase in income
increases both C1 and C2 . Hence, for C1 there is a negative substi-
tution effect and a positive income effect. If σ > 1 the substitution
effect dominates. If σ < 1 the income effect dominates. If σ = 1 (log
utility) the income and substitution effects exactly offset each other,
and C1 does not change.
(c) What additional effect comes in if we assume Y2 > 0?
solution with a positive Y2 a decrease in p2 reduces the value of period 2
endowment. Hence, there is an additional negative wealth effect that
reduces both C1 and C2 . Note that the income effect is given by
∂C1
C2
∂I

3
 where I = Y1 + p2 Y2 . The wealth effect is given by
∂C1 ∂I ∂C1
− =− Y2
∂I ∂p2 ∂I
Hence the combined income and wealth effect is
∂C1
(C2 − Y2 )
∂I
5. Suppose a foreign country has the same preferences as the home country,
equal date 1 output Y1∗ = Y1 but different date 2 output Y2∗

(a) Assume higher income growth in the home country, i.e. Y2 > Y2∗ .
Derive the autarky interest rate in both countries and compare.
solution The autarky interest rate rA is the interest rate that induces
the agent to set consumption equal to income in both periods (the
only possible allocation in a closed economy, as we don’t have real
capital in our model). With CRRA utility the FOC in autarky is
1
−σ
βC2 1
−1
=
C1 σ 1 + rA

We find the autarky interest rate by inserting for the only possible
equilibrium allocation when there’s no trade Ct = Yt and solve for
the interest rate
 1
1 Y2 σ
1 + rA =
β Y1
1
1 Y2∗ σ

∗
1 + rA =
β Y1∗
∗
rA < rA

The home country has a higher income growth. Hence, if the Home
autarky interest rate was the same as the Foreign, the home country
would want to borrow in period 1. But it is not possible to bor-
row in autarky, hence the Home autarky interest rate must therefore
increase to reduce the borrowing motive.
extra How can we be sure that borrowing motive will go down, or equiv-
alently, the saving motive will go up, when the interest rate increase?
From above we know that the substitution effect tends to reduce
C1 and thus increase saving, and since the Home country wants to
∗
borrow if the interest rate equals the Foreign autarky rate rA , the
combined income and wealth effect is negative (Y2 > C2 as long as
you are a borrower), which also reduces C1 .

4
extra In autarky, income and wealth exactly offset each other, and we
are left with only substitution effect. Consequently, in a graph with
r along the vertical axis and savings along the horisontal, the slop of
the savings schedule will always be positive at the autarky interest
rate. Below the autarky interest rate, we have negative savings and
the income+wealth effect is negative, hence the slope will be pos-
itive. But for r above the autarky rate, the income effect+wealth
effect is positive and the slope will turn negative at sufficiently high
r (provided σ < 1). But it will never cross the vertical axis twice,
since there is only one autarky interest rate!
extra Note that the autarky interest rate is bounded below at −1
  σ1
1 Y2
rA = −1
β Y1
  σ1
1 Y2
since β Y1 > 0.
(b) Suppose the world market consists of these two countries. State the
equilibrium condition, and show in a graph how the interest rate will
be determined. Which country will run a current account surplus in
period 1? Intuitively, what are the gains from trade?
solution Since there is no capital in this model, the world saving in period
1 S1w has to be zero, i.e.

Sw = S + S∗ = 0

where S = Y1 − C1 and S ∗ = Y1∗ − C1∗ .Note that in a model without

capital, the current account equals saving CA1 = S1 . The home and
foreign saving depends on the interest rate. The equilibrium interest
rate r is the rate that makes

S(r) = −S ∗ (r)

Home country will run a current account deficit and Foregin a sur-
plus.Trade allows countries smooth consumption intertemporally by
investing in the international financial market. Since the autarky al-
location always is possible (you can always choose to consume your
income) trade simply increases the consumption possibilities, and the
country cannot be worse.
(c) Using the answer from question 2. what happens to welfare in the
home country if the foreign country’s output growth increases ( Y2∗
up)?
solution If Y2∗ increases rA
∗
goes up and r goes up. Since Home is a
borrower in period 1 its welfare goes down (worsening of terms of
trade).

5
6. We now extend the model to include a production side. Each country has
access to the same technology and the technology does not change. The
production function is Y = F (N, K) where N and K are respectively
the inputs of labor and capital. The production function is homogeneous
of degree one and has standard neoclassical properties. The labor input is
given exogenously and is the same in both countries and both periods. Each
country has inherited a capital stock from the past, K1 and K1∗ respectively,
that can be used in production in period 1. The capital stock can be aug-
mented by investment in period 1, which then adds to the input of capital
in period 2, K2 and K2∗ . At the end of period 2 the remaining capital
stock is consumed. The budget constraint of the home country can then be
written
C2 + I2 Y2
C1 + I1 + = Y1 +
1+r 1+r
where I1 = K2 − K1 and I2 = −K2 . Explain how the home country’s
investment demand in period 1 is determined and what the inclusion of
capital means for the relationship between the world interest rate and the
home country’s current account in the first period.

Solution We assume zero depreciation. Home country’s investment de-

mand is derived from the demand for date 2 capital K2 . The optimal
capital is pinned down by the equalization of return on domestic real
capital and the golbal interest rate:
FK (N, K2 ) = r
and investment demand is (assuming zero depreciation):
I1 = K2 − K1
The current account is now given by CA1 = S1 − I1
• Effect of r on I1 : If the interest rate increases, investment de-
mand goes down. Marginal productivity of capital is now initialy
lower than the world interest rate. The country will therefore
save less in domestic capital and more in the international finan-
cial market, until equalization of rate of return is restored.
• Effect of r on S1 : We discussed the effect of above. But because
of capital there is an additional effect. Remember that we have
separation of investment and savings decision. This means that
we can think of the agent’s problem of making optimal invest-
ment, consumption and savings choices in two stages: First the
optimal date 2 capital stock K2 is pinned down by the global
interest rate. Second, given the optimal K2 , the agent makes
optimal consumption-savings decisions subject to the life-time
budget constraint
C2 Y2 − rK2
C1 + = K1 + Y1 + ≡M
1+r 1+r

6
 where the RHS is (as before) the present value of resources,
denoted by M . We have income and substitution effects on
C1 as before (effects, holding M constant). Is the wealth ef-
fect still negative? i.e. what is the effect of and increase in r
on M ? The wealth effect via the term Y2 − rK2 is given by
FK dK dK2
dr − r dr − K2 = −K2 (again because of the envelope con-
2

dition), hence the wealth effect is given by

dM Y2 − rK2 K2 (Y2 + K2 )
=− − =−
dr (1 + r)2 1+r (1 + r)2
• Consequently, the income and substitution effects on C1 , are the
same as in the model without investment, and the wealth effect
is still negative. In addition investment is decreasing in r.
extra We know that the CA1 (r) schedule is increasing in r as long r
is not too high. Why? First, the effect via I1 is always postive.
What about the effect via S1 ? The substitution effect on C1 is
negative and the combined income and wealth effect on C1 is
given by
∂C1 1 ∂C1 ∂M ∂C1 1
C2 + = (C2 − Y2 − K2 )
∂M (1 + r)2 ∂M
| {z ∂r} ∂M (1 + r)2
| {z }
income effect wealth effect

So, in autarky we have that C2 − Y2 − K2 = 0, hence, in-

come+wealth effect is zero (as in the model without capital).
When we run a current account deficit in period 1, we must
have a current accunt surplus in period 2: CA1 < 0 ⇒ CA2 =
Y2 − C2 + K2 > 0, and the income+wealth effect on C1 is neg-
ative. Hence, the CA1 is increasing in r when CA1 < 0. When
CA1 > 0 then CA2 = Y2 − C2 + K2 < 0, and the income+wealth
effect on C1 is positive. If r is sufficiently above the autarky
interest rate, the slope of CA1 (r) could turn negative, provided
σ < 1.
7. Compare the capital stocks of the two countries in the second period. Sup-
pose the home country has inherited more capital than the foreign country
( K1 > K1∗ ). What does this imply for the current accounts in the two
periods?
solution The capital stock in period 2 will be the same in both countries.
Suppose that K1 = K1∗ . This means that the two countries are equal,
and the only equilibrium is that CA1 = CA∗1 . Suppose, home country
gets more capital.
(1) what happens to C1 ? An increase in K1 will increase the RHS of the
budget constraint
C2 Y2 − rK2
C1 + = K1 + Y1 +
1+r 1+r

7
 because Y1 + K1 = F (K1 ) + K1 goes up. The consumer is richer
and will therefore increase consumption but less than the increase in
Y1 + K1 (want’s to smooth)
(2) The current account is given by

CA1 = S1 − I1
= Y1 − C1 + K1 − K2
= Y1 + K1 − C1 − K2

since K2 is unchanged and C1 increases less than the increase in

Y1 + K1 the current account improves. Hence the CA schedule shifts
to the right, and we can use the graph to determine the equilibrium.
Home (Foreign) country will run a current account surplus (deficit)
in period 1 and vice versa in period 2.
(3) Note that this implies that the world market interest rate is higher
than the Home autarky interest rate. The autarky interest rate de-
fined as the interest rate that makes investment=savings (must hold
in a closed economy)

CA1 (rA ) = 0
S1 (rA ) = I(rA )

In the graph we find rA as the intersection between the current ac-

count schedule and the vertical axis. Since marginal product of cap-
ital is always equal to the interest rate, the period 2 capital stock in
the Home country will be higher in autarky than in an open economy.

8. Finally, suppose international borrowing and lending had not been possible.
From the point of view of wage earners in the home country, would this
be an advantage or a disadvantage?

solution marginal productivity of labor (wages) are increasing in the cap-

ital stock. Nothing happens to wages in period 1, since the initial
capital stock is determined from the past. But period 2 wages in the
home country will be lower than under autarky, since some of the
savings that in autarky went to capital investment are now invested
in the international financial market.

Part 2
In this problem we consider an infinite horizon model with a representative
agent and perfect foresight. Each period, the agent must obey the following
budget constraint:
Cs + Bs+1 = Ys + (1 + r)Bs

8
1. Based on the fact that the budget constraint holds for every period from
t to t + T , show that this implies
t+T
X s−t
1 Bt+T +1
(1 + r)Bt = (Cs − Ys ) +
s=t
1+r (1 + r)T

Solution Since the period-by-period budget constraint holds for every

period t to t + T we have
1
Bt = (Ct − Yt + Bt+1 )
1+r
1
Bt+1 = (Ct+1 − Yt+1 + Bt+2 ) (4)
1+r
1
Bt+2 = (Ct+2 − Yt+2 + Bt+3 ) (5)
1+r
... (6)
1
Bt+T = (Ct+T − Yt+T + Bt+T +1 ) (7)
1+r
Using these constraints, start by re-writing the period t budget con-
straint
(1 + r)Bt = Ct − Yt + Bt+1
Inserting for Bt+1 using eq 4
1
(1 + r)Bt = Ct − Yt + (Ct+1 − Yt+1 + Bt+2 )
1+r
| {z }
Bt+1

Continue by substitute for Bt+2 using eq 5

 

1  1 
(1 + r)Bt = Ct − Yt + Ct+1 − Yt+1 + (Ct+2 − Yt+2 + Bt+3 )
 
1+r  1+r
| {z }
Bt+2
| {z }
Bt+1
Ct+1 − Yt+1 Ct+2 − Yt+2 Bt+3
= Ct − Yt + + +
1+r (1 + r)2 (1 + r)2

and continue up to period T .

2. Explain the intuition behind

Bt+T +1
lim =0
T →∞ (1 + r)T

9
 solution First: why not limT →∞ B(1+r)
t+T +1
T < 0? To rule out Ponzi schemes,

in which the agent could pay interest on existing debt by issuing new
debt for ever. If this was allowed there would never be any transfers
from the agent to the lenders (since the interest payments due each
period would be financed by borrowing more), and the present value
of consumption is larger than the present value or resources:
∞  s−t ∞  s−t
X 1 X 1
Cs > Ys + (1 + r)Bt
s=t
1+r s=t
1+r

This would require the lenders to hand over resources for free to
the agent. The lenders would not accept this scheme. Why not
limT →∞ B(1+r)
t+T +1
T > 0? Not really a constraint, but it follows from
utility maximization, so we simply impose it immediately. If > 0 the
consumer does not spend all its resources in present value terms:
∞  s−t ∞  s−t
X 1 X 1
Cs < Ys + (1 + r)Bt
s=t
1+r s=t
1+r

and would hand over resources for free. Intuitively, the agent could
increase consumption and not violate the life-time budget constraint.
(See Obstfeldt and Rogoff pp. 63-66 for more on this)

3. Impose this restriction and assume that Cs = cYs and Ys = (1 + g)s−t Yt .

(a) Find the intertemporal budget constraint for this case (when g < r).
solution The intertemporal budget constraint (aka life-time budget con-
straint) is found by letting T → ∞ and imposing the restriction
limT →∞ B(1+r)
t+T +1
T = 0

∞  s−t
X 1
(1 + r)Bt = (Cs − Ys )
s=t
1+r

if we further assume that Cs = cYs and Ys = (1 + g)s Yt we get

∞  s−t
X 1+g
(1 + r)Bt = Yt (c − 1)
s=t
1+r
1+r
(1 + r)Bt = Yt (c − 1)
r−g
c−1 Bt
=
r−g Yt
P∞  1+g s−t
where we have used that the infinite sum s=t 1+r converges
when g < r (⇒ (1 + g)/(1 + r) < 1).

10
(b) Imagine that keeping consumption at a fixed share c of output indeed
is the optimal consumption-choice of a representative agent. Is c
above or below one?
solution Use the intertemporal budget constraint to solve for the maxi-
mal sustainable level of c.
Bt
c = (r − g) +1
Yt
If the agent initially has positive assets Bt > 0 then c > 1. If the
agent initially has debt Bt < 0 then c < 1
(c) Assume g = 0. What does the time-profile of Bt look like for a given
value of c?
solution if g = 0 then Ys = Yt = Y is constant. We get
Bt
c=r +1
Y
so
C = cY = rBt + Y
Hence the agent consumes the interest on the asset each period and
the Bt stays constant. The evolution of Bt+1 is given from the period-
by-period budget constraint

Bt+1 = Y − C + (1 + r)Bt
= Y − (rBt + Y ) + (1 + r)Bt
= Bt

and so on. Hence, Bt is constant. This amounts to consuming income

Y plus (minus) interest payment on initial asset (debt) rBt each
period.
(d) Assume g > 0 (but also g < r). What does the time-profile look like
now?
solution The solution for c is now
Bt
c = (r − g) +1
Yt
Bt+1 is given by

Bt+1 = Yt − Ct + (1 + r)Bt
= Yt (1 − c) + (1 + r)Bt
= (r − g)Bt + (1 + r)Bt
= (1 + g)Bt

11
 Bt+2 is given by

Bt+2 = Yt+1 − Ct+1 + (1 + r)Bt+1

= (1 + g)Yt − c(1 + g)Yt + (1 + r)(1 + g)Bt
= (1 + g)(Yt − Ct + (1 + r)Bt )
= (1 + g)Bt+1

and so on. Hence Bs grows at the same rate as income Ys ,keeping

Bs /Ys constant. Consumption in period s is given by
Bt
Cs = cYs = (r − g) Ys + Ys
Yt
= (r − g)Bt (1 + g)s−t + Ys
= (r − g)Bs + Ys

Hence consumption in period s equals current income plus the growth-

adjusted interest rate on current asset.

4. Now assume (as in question 6 of the first problem) that output is a function
of thePcapital stock, Yt = At F (Kt ). The utility function is specified as
∞
Ut = s=t β s−t u(Cs ). Use the period s budget constraint to insert for Cs
in the utility function.

(a) Find the first-order condition with respect to Kt+1 and Bt+1
solution The period-by-period budget constraint is now

Cs + Bs+1 + Ks+1 = As F (Ks ) + Ks + (1 + r)Bs

substitute this into the objective function to get the maximization

problem
∞
X
max β s−t u(As F (Ks ) + Ks + (1 + r)Bs − Bs+1 − Ks+1 )
{Ks+1 ,Bs+1 }∞
s=t s=t

The foc wrt Bt+1 is

u0 (Ct ) = β(1 + r)u0 (Ct+1 )

and wrt Kt+1 is

u0 (Ct ) = β(1 + As F 0 (Kt+1 ))u0 (Ct+1 )

combining them gives

As F 0 (Kt+1 ) = r

So we have the standard Euler equation for consumption + the op-

timal investment condition.

12
(b) Suppose productivity is constant As = At for all s ≥ t and that, by
coincidence, β(1 + r) = 1. Describe the time-profiles of consumption,
investment and the current account (you can assume that initial net
foreign assets, Bt , are zero).
solution Consumption is constant in all periods and investment and
current account is equal to zero in all periods but the first. Since
β(1 + r) = 1 consumption is constant. Let K ∗ be the capital stock
that equalizes the marginal product of capital with world market
interest rate r
AF 0 (K ∗ ) = r
investment in the initial period t is It = Kt+1 − Kt = K ∗ − Kt , the
sign depends on the initial level of capital. Investment in all future
periods is zero. What about the current account CAs = Bs+1 − Bs ?
In the initial period t it is given by

CAt = Bt+1 = Yt − C ∗ − It

and in all future periods s > t it is given by

CAs = Bs+1 − Bs = Y ∗ − C ∗ + rBs

The only possible value is CAs = 0 and thus Bs = Bt+1 for all
s ≥ t+1 Why? If CAs is not zero the country will accumulate debt or
assets for ever, which either violates the no-Ponzi scheme condition
(in the case of debt) or is suboptimal (in the case of assets), thus
violating the condition limT →∞ B(1+r)
t+T +1
T = 0. To see this look at the

growth rate of Bs+1 from the current account. If Y ∗ − C ∗ > rBs

Bs+1 − Bs Y ∗ − C∗
=r+
Bs Bs
∗ ∗
When Bs grows for ever, the term Y B−C s
goes to zero, and in the
limit Bs grows at rate r. The initial current account CAt depends
on the initial capital stock. If Kt = K ∗ then also CAt = 0. If the
country has Kt < K ∗ , then it will run a initial deficit, and if Kt > K ∗
it runs a surplus (same argument as in question 7 in problem set 1)
(c) Sketch the effects on consumption, investment and the current ac-
count from
i. An unexpected temporary increase in productivity in period t + 1
(that only lasts one period)
solution Variables will jump in period t+1 (nothing happens in pe-
riod t since the change is unexpected). When productivity in-
creases only in period t + 1 , investment does not react (since
marginal productivity of capital is back at its normal level the
next period). The country thus gets a one-time increase in out-
put. Consumption still constant, but jumps to a higher level.

13
 The jump is less than the one-time increase in output because
of consumption smoothing. The country saves a fraction of the
temporary high output in international financial markets, hence
the current account is positive in period t + 1 and then zero.
ii. A temporary increase in productivity in t + 1 (that only lasts one
period) that becomes known at the beginning of period t
solution Now investment reacts. The country invests in capital
in period t to take advantage of high productivity in the next
period. Consumption increases immediately to a permanent
higher level. To finance both more consumption and investment,
the country borrows from abroad by running a current account
deficit in period t. In period t + 1 investment is negative since
the capital stock returns to K ∗ in period t + 2 and zero there-
after. The current account in period t + 1 is positive and zero
thereafter.
iii. An unexpected permanent increase in productivity
solution Investment adjust immediately in period t and then re-
turns to to zero. Consumption increases permanently. Output
increases immediately due to higher productivity. In period t + 1
in increases even further since the capital stock is now higher.
Consumption therefore increases more than output in period t
so savings goes down. Both higher investment and lower savings
gives a current account deficit in period t and zero thereafter.

14