An Anticipated Output Shock

Consider a two-period small open endowment economy populated by a large number of households with preferences described by the lifetime utility function:

11

U=C1^1/10 * C2^1/11

Suppose that households receive exogenous endowments of goods given byQ1=Q2= 10 in periods 1 and 2, respectively. Every household enters period 1 with some debt, denotedB0, inherited from the past. LetB0=5. The interest rate on these liabilities, denotedr0, is 20 percent. Finally, suppose that the country enjoys free capital mobility and that the world interest rate on assets held between periods 1 and 2, denotedr, is 10 percent.

1. aCompute the equilibrium levels of consumption, the trade balance, and the current account in periods 1 and 2. Do not forget to show step by step your algebraic calculations. Explain in detail your reasoning.
2. b Assume now that the endowment in period 2 is expected to increase from 10 to 15. Calculate the effect of this anticipated output increase on consumption, the trade balance, and the current account in both periods. Provide intuition. Do not forget to show step by step your algebraic calculations. Explain in detail your reasoning.