Exercise 13 Consider a small open economy that exists for two periods and that possesses an initial stock of assets B1 , 0, i.e., that there is indebtedness inherited from a period before the initial. The stock of assets at the end of the first period is given by B2 2 B1 5 rB1 1 Y1 2 C1. Assume that the relation βð1 1 rÞ 5 1 is valid. The endowment for the first period is given by Y1 and the endowment for the second period is equal to zero.

a. Present the intertemporal budget constraint and the conditions that establish the optimum levels for consumption and investment.

b. What would be the effect of a reduction in debt (a reduction in j j B1 ) on the present value of income in the country? What would be the impact on consumption and current account in the first period?