1. Consider a two-period, small, open economy with free capital mobility. Households are endowed with 20 units of the tradable good in period 1 and 20 units of the tradable good in period 2: Q = 20 Q2 = 20. In addition to this income they also receive wages from labour supply to the market for non- tradable goods production and receive any profits generated by firms. The world interest rate is r, the nominal exchange rate, defined as the price of foreign cur- rency in terms of domestic currency, E, is fixed and equal to 1 in both periods. The foreign currency price of the tradable good, P, is constant and equal to 1 in both periods and the law of one price holds for tradable goods. Assume initially that households can borrow and lend freely on world markets using an international bond, B, which pays 1 unit of tradable good. Nominal wages are downwardly rigid. Assume that the nominal wage in periods 1 and 2, measured in units of the domestic currency, can not fall below the past wage rate: Wt > W-1 for t = 1,2 and Wo= 10. The nominal wage can rise, but not fall. Households start period 1 with no assets or debts from the past. Household preferences are given by In C+ In C+ In C + In C where CT and CN denote the consumption of tradables and nontradables in each period. Let pand p be the relative price of nontradables in terms of tradables. Households supply inelas- tically h = 1 units of labor to the market each period. Firms produce nontradable goods using labor as the only input to production. They have production technology QN QN = = hq h where h and h are the firms labour demand in each period t and the parameter satisfies a=0.5. Any profits of the firm are paid to households as a lump-sum. NOTE: You do not need to given numerical answers until part f. a. Suppose that the period 2 tradable endowment is uncertain. The expected endowment remains equal to 20, but with probability one half it will be equal to 10, and with prob- ability one half it will equal 30. Compared with the model in part A in which the real interest rate is equal to zero, describe how the presence of uncertainty is likely to affect the equilibrium outcomes in periods 1 and 2. Explain when and why nominal wage rigidities can cause unemployment. Be sure to comment on the implications for the relative price of nontradables and the real exchange rate. b. Now suppose there is no uncertainty but instead that the period 2 tradable endowment is unexpectedly low and equal to 10 in period 2. Discuss the equilibrium outcomes in periods 1 and 2. What are the economic outcomes in response to this unanticipated development. Explain the role of nominal wage rigidities for employment, the relative price of non-tradables and the real exchange rate. Compare these outcomes to part 2a. Will unemployment will be higher or smaller? What about the real exchange rate? Why?