Consider a two-period economy that has at the beginning of period 1 NIIP of 100: In period 1, the country

runs a current account deficit of 5 percent of GDP, and GDP in both periods is 120. Assume the interest

rate in periods 1 and 2 is 10 percent. At the end of period 2, the NIIP must be equal to zero.

1. Find the level of the trade balance in period 1, the level of the current account balance in period 1;

and the country's NIIP at the beginning of period 2.

2. Is the country living beyond its means? To answer this question, find the country's current account

balance in period 2 and the associated trade balance in period 2. Is this value for the trade balance

feasible? [Hint: Keep in mind that since expenditures cannot be negative, the trade balance cannot

exceed GDP].

3. Now assume that in period 1, the country runs instead a much larger current account deficit of 10

percent of GDP. Find the country's NIIP at the end of period 1. Is the country living beyond its

means? If so, why?

4. More generally, what is the maximum current account deficit (as a share of GDP) that this country

can have at time 1 and still live within its means?