International Macroeconomics

Consider a small open economy that exists only for two periods, t= 1.2. Although there is no uncertainty regarding the first period output. the representative consumer is uncertain about output in t= 2 when there are two states of nature. The only difference between the two states is the output realizations in the two states.

i) By solving the utility maximization problem of the representative consumer in this economy derive the condition under which it is optimal to equate consumption in both states, i.e., C3(1) =C2(2)

ii) Now assume that there are two countries that make up the world and that they have identical structures in that they have the same degree of relative risk aversion and the same form of utility function. What is the relationship between the domestic and world consumption in global equilibrium?

iii) Is it possible to reconcile the very low levels of international consumption risk-sharing that is evident from consumption correlations across the G7 countries with the significant integration of financial markets since early 1990s? Explain your answer fully

4. Consider a small open economy that exists only for two periods, t = 1, 2. Although there is no uncertainty regarding the rst period output, the representative consumer is uncertain about output in t = 2 when there are two states of nature. The only dierence between the two states is the output realizations in the two states. The individuals lifetime expected utility on date 1, U1 is given by U1 = v{1){v(01}+ v [02(1Jl} + 1T(2)1'[v(01}+ viczii'H} (1) where Cl and 02 are consumption in periods 1 and 2 respectively, a(C) is the utility arising from consuming C: and 1T{l) and 17(2) are the probabilities of states 1 and 2 occurring. Assume that there is a world-wide market to buy and sell contingent claims of all types. Dene 321(3) as the representative individual's net purchase of state a securities in period 1 and therefore the stock of these securities at the beginning of date 2. Also, 1%% is the price of state a securities in terms of period 1 consumption. i) By solving the utility maximization problem of the representative consumer in this economy derive the condition under which it is optimal to equate consumption in both states, i.e., (lg-{1) = 02 [2]. [35%] ii) Now assume that there are two countries that make up the world and that they have identical structures in that they have the same degree of relative risk aversion and the same form of utility function. What is the relationship between the domestic and world consumption in global equilibrium? [35%] iii) Is it possible to reconcile the very low levels of international consumption risksharing that is evident from consumption correlations across the G7 countries with the sig nicant integration of nancial markets since early 19903? Explain your answer fully. [30%]