International Macroeconomics

Exercise 3. Consider a small open economy with 2 periods. Households receive endowment Y2 in period 2 and are taxed T2 (lumpsum) by the government. Households don't have any savings or borrowing. The government has an outstanding stock of government debt B = 1.5 issued in period 1, which implies repaying B(1 + 'r) in period 2 (if the government decides to repay). Suppose this debt is held by riskneutral foreign investors that can access borrowing/ lending at the riskfree international interest rate 'r* = 10%. The government is benevolent and chooses to repay or default (entirely) on its debt to maximize consumption in period 2 for the households. If the government defaults, the available endowment for consumption is given by Yg(1 c), where c = % is the proportional cost of default. Fi~0m the perspective of period 1, Y2 is a random variable that can take the value of Yg = 10 with probability 0.5 and Y = 6 with probability 0.5. (a) Write down the budget constraints for the households and the government in period 2 if the government decides to repay. Write down the budget constraints for the households and the government in period 2 if the government decides to default