(2.A.) Consider two separate shocks: (i.) A decrease in R to R = 1.2 and (ii.) An increase

in z2 to z2 = 5. Complete Table 1 and explain why these two shocks have the same qualitative effect

on the trade balance in period 1 but have opposite effects on household welfare. (This question helps us

understand why we should not equate an increase in the trade deficit with a fall in welfare.)

(2.B.) Draw a household consumption diagram to show the qualitative effect of the first

shock in (2.A.) (a fall in the interest rate) on the trade balance in period 1 and household welfare. Your

diagram should show the exact consumption and trade balance values in each period but your indifference

curve should be drawn schematically.

Table 1: Dynamic Small Open Economy Variable Initial Economy Shock (i. ) Economy Shock (ii.) Economy R = 1.2 22 = 5 C1 C2 TB1 TB2 Utility