Assume a two-period small open economy model, where the national product is 50 in the current period, and 88 in the future period. The world real interest rate is 10% per period. The representative consumer has the following utility function:

U (c, G, c’, G’) = in (c + G) + in (c’+ G’).

a). What are the optimal consumption plus government spending in the current and in the future period? What is the current account surplus? Show this in a diagram.

b). Now, suppose that governments in the rest of the world impose a tax on lending to foreigners of 5%. Determine how this affects consumption plus government spending in the present and the future, and the current account surplus. Explain your results.