Gains From International Financial Integration

Consider the Inter-temporal Model with two time periods, t=0 and t=1. Home is a small open economy that can borrow and lend in the first period at the world real interest rate of 2%. In the first period, output is Y_o= 200. Because of a crop disease, output in the second period is expected to fall to Y₁= 150. The country wants to smooth consumption as much as possible. The country begins with no external assets or liabilities.

Question 6.) Solve for consumption, the current account, and the financial account in the first period.

Question 7.) Solve for the trade balance, the current account, and the financial account in the second period.

Question 8.) Would home be better off or worse off if the interest rate were higher than the initial 2%?

A. Worse off, home is a borrower, so an increase in the interest rate increases home's expenses.

B. Worse off, home is a lender, so an increase in the interest rate increases home's earnings.

C. Better off, home is a lender, so an increase in the interest rate increases home's earnings.

D. Better off, home is a borrower, so an increase in the interest rate increases home's expenses.