Consider the case of a home country where under normal conditions the level of

GDP is Q=1000 and consumption C=1000 and I=G=0. Initially, these conditions are

expected to last forever.

The world interest rate is r*=0.05=5%. Assume it is now time 0, and that external

wealth at the end of all previous period was zero.

a. At time 0, under this scenario [1]:

What is the present value of output? PV(Q) = _____________

What is the present value of consumption? PV(C) = _____________

b. Now suppose conditions have changed, and the country has learned of a negative

output shock at time t=0.

This shock is expected to last one year, and will lead to an output drop of 210

units. That is, GDP at time 0 falls to Q0 = 790, then returns to 1000.

At time 0, under this scenario [1]:

What is the present value of output? PV(Q) = _____________

What is the present value of consumption? PV(C) = _____________

Assume forward-looking agents desire smooth consumption over time.

Compute the new planned levels of consumption at t = 0 and 1 under this

scenario. [1]

C0 = _____________

C1 = _____________

Compute the trade balance, NFIA, current account, and wealth at t = 0 and 1

under this scenario. [1]

TB0 = ___________ NFIA0 = ____________ CA0 = ______________ W0 = ______________

TB1 = ___________ NFIA1 = ____________ CA1 = ______________ W1 = ______________

c. Suppose period 0 ends as above. Now it is time 1, and suppose conditions have

changed again, and the country learns of an identical negative output shock at

time t=1. This shock is expected to last one year, and will lead to another output

drop of 210 units. That is, GDP at time 1 falls to Q1 = 790, instead of 1000.

Compute the new planned levels of consumption at t = 0, 1, 2 under this scenario

building on what has already happened in t=0. [1]

C0 = _____________

C1 = _____________

C2 = _____________

Compute the trade balance, NFIA, current account, and wealth at t = 0, 1, 2 under

this scenario building on what has already happened in t=0. [1]

TB0 = ___________ NFIA0 = ____________ CA0 = ______________ W0 = ______________

TB1 = ___________ NFIA1 = ____________ CA1 = ______________ W1 = ______________

TB2 = ___________ NFIA2 = ____________ CA2 = ______________ W2 = ______________

d. Now return to that initial situation at t=0. Now suppose agents had learned at

time t=0 that output was going to be at the level of 790 in both years 1 and 2,

instead of 1000.

At time 0, under this scenario:

What is the present value of output? [1] PV(Q) = _____________

What is the present value of consumption? [1] PV(C) = _____________

How would planned levels of consumption differ here from the previous case

where agents only learned in each year about the output drop in that year? [2]