Consider a two-period small open endowment economy populated by

a large number of households with preferences given by the lifetime utility

functionC1C2 , where C1 and C2 denote consumption of food in periods

1 and 2. Suppose that households receive exogenous endowments of copper

given by Q1 = Q2 = 10 in periods 1 and 2. The terms of trade in periods 1

and 2 are TT1 = TT2 = 1. Every household enters period 1 with no assets

or liabilities inherited from the past, i.e., B0 = 0. Finally, suppose that

the country enjoys free capital mobility and that the world interest rate on

assets held between periods 1 and 2 is 5 percent.

a. Compute the equilibrium levels of consumption, trade balance, and

current account in periods 1 and 2.

b. Assume now that the terms of trade in period 2 are expected to in-

crease by 50 percent. Calculate the effect of these anticipated terms of trade

improvement on consumption, trade balance, and current account in periods

1 and 2. Provide intuition.