Q2. (3) (b) (C) Consider the two-period small open economy model, which takes the world interest rate, r, as given. 91-01-11 =Bi* (I) 92 + n91\" - C2 = -31* (2) K2=K1 +1; (3) Where Q is output, C is consumption, 1 is investment, r is interest rate, K is capital and B* is the net claims of a countries residents on residents in the rest of the world. (i.e. if B* is positive the country is a net creditor) Recall that depreciation is set equal to zero and labour force assumed constant (all that can be chosen is the I 1. ) Assume 130* = B 2* =3] *=0 and draw the transformation curve graphing Q1- 1] against Q2. . Optimal investment will be given by MPKZ = 1 +r. and optimal consumption will be given by - (1+p) V'(C1)/V'(C2) = -(I +r) Hence illustrate the trade balance on your diagram. Use the diagram to illustrate how different kinds of shocks will affect the trade balance. Explain. [9/520]