Economics 1G2 Spring H122 Globalization Problem Set 3: International Capital Markets May 12, 2:122 1 lntertemporal Trade Present a brief explanation for why the theory of international capital markets can be recast as a theory of international trade over time. What are key differenoes between trade in goods and services as compared to the exchange of capital? What gains from international investment are there beyond those of intertemporal trade? What are the risks associated with intertempora] trade? Consider the effects of capital market integration. 1.1. An economy has an endowment of income of Fm, and invests a strictlyr positive amount of that income IN, for future consumption. Draw the economy's intertem poral production possibility frontier and demonstrate today's consumption, today's investment, tomorrow's consumption, and tomorrow's income in a closed economy. 12. Now assume the economy has access to international capital markets at the world interest rate {l+r*j. What will this do to the economy's consumption and investment decisions? Again, draw the economy's intertemporal production possibility frontier and demonstrate today's consumption, today's investment, tomorrow's consump- tion, and tomorrow's production in an open economy. \fExplain how a provoked inability to repay sovereign debt (under hidden action) changes the standard case of intertemporal trade, and relate the idea of minimum guaranteed con- sumption to bailouts. Then explain two scenarios under which lacking willingness to repay can be concealed as lacking ability.3 Sovereign Risk Explain why higher default risk increases the interest rate. Provide a numerical example to illustrate your verbal explanation. Explain how a lacking willingness to repay sovereign debt (lacking international en- forceability of contractual stipulations) changes the standard case of intertemporal trade. For this purpose, elaborate the moral hazard problem associated with international debt service and default. Distinguish between ability and willingness to repay.\f5 Debt Management and the Debt Laffer Curve Take the role of a macroeconomic consultant to a national government with an outstanding debt burden that requires management. Suppose the "Debt Laffer" Curve takes a pecu- liar kinked shape: the market value V of outstanding debt grows at a rate of 1:1 with the face value D of the debt up to a certain debt level of _ and that the market value of debt subsequently stays constant. Suppose the country's outstanding face value of debt is currently $1 billion US dollars and that one unit of the debt currently trades at 30 cents on the dollar. . What is the current market value V of outstanding debt (in $)? . Propose a complete strategy for the debtor country to reduce its debt burden V to the minimally possible amount, by optimally combining debt forgiveness and debt buybacks, under the condition that the debtor country is no worse off at any step in terms of net resource outflows compared to its preceding debt position. For each proposed step of your strategy - remark whether you propose forgiveness or buyback, - state the market value v of one unit of debt at the start and at the end of the step, and - state the outstanding face value D at the start and at the end of the step . Can the country fully eradicate its debt? Why or why not? . Would the strategy work for a typical Debt Laffer Curve that is smooth (no kinks)?