Section 1.

Consider a two-period small open economy populated by a large number of

identical households with preferences described by the utility function

lnCT 1 + lnCN 1 + lnCT 2 + lnCN 2

where CT 1 and CT 2 denote consumption of tradables in periods 1 and 2, respectively, and CN 1 and CN 2 denote consumption of nontradables in periods

1 and 2. Households are born in period 1 with no debts or assets and are

endowed with L1 = 1 units of labor in period and L2 = 1 units of labor in

period 2. Households o?er their labor to ?rms, for which they get paid the

wage rate w1 in period 1 and w2 in period 2. The wage rate is expressed in

terms of tradable goods. Households can borrow or lend in the international ?nancial market at the world interest rate r?. Let pN 1 and pN 2 denote the

relative price of nontradable goods in terms of tradable goods in periods 1

and 2, respectively.

Firms in the traded sector produce output with the technology QT 1 = aTLT 1 in period 1 and QT 2 = aTLT 2 in period 2, where QT t denotes output in period t = 1,2 and LT t denotes employment in the traded sector in period t = 1,2.

Similarly, production in the nontraded sector in periods 1 and 2 is given by

QN 1 = aNLN 1 and QN 2 = aNLN 2 .

1. Write down the budget constraint of the household in periods 1 and 2.

2. Write down the intertemporal budget constraint of the household.

3. State the household's utility maximization problem.

International Macroeconomics, Chapter 9 299

4. Derive the optimality conditions associated with the household's max

imization problem.

5. Derive an expression for the optimal levels of consumption of trad

ables and nontradables in periods 1 and 2 (CT 1 , CN 1 , CT 2 , and CN 2 ) as functions of r?, w1, w2, pN 1 , and pN 2 .

6. Using the zero-pro?t conditions on ?rms, derive expressions for the real wage and the relative price of nontradables (wt and pN t , t = 1,2),

in terms of the parameters aT and aN.

7. Write down the market clearing condition for nontradables.

8. Write down the market clearing condition for labor.

9. Using the above results, derive the equilibrium levels of consumption ,

the trade balance, and sectoral employment (CT 1 , CT 2 , CN 1 , CN 2 , TB1, TB2, LT 1 , and LT 2 ) in terms of the structural parameters aT, aN, and r?.

10. Is there any sectoral labor reallocation over time? If so, explain the

intuition behind it.

4. Increased government spending for investments such as highways or harbours financed by 1. In Year 1. the actual budget deficit was $200 billion and the cyclically adjusted deficit was increasing the public debt would most likely; $150 billion. In Year 2. the actual budget deficit was $225 billion and the cyclically adjusted increase the amount of public capital stock in the future. deficit was $175 billion. It can be concluded that fiscal policy from Year I to Year 2 was: increase the amount of private capital stock in the future. proportional. crowd out future public investment. contractionary. reduce the economy's future productive capacity. expansionary inflationary. 5. An expansionary fiscal policy in Canada might unintentionally cause demand-pull inflation if: 2. Refer to the diagram below wherein T is tax revenues and G is government expenditures. All the policy produces severe crowding out. figures are in billions. In this economy: the dollar unexpectedly depreciates while the expansionary policy is in place. T.G ($) our trading partners experience recession during the time of the fiscal policy action. 400 300 the dollar unexpectedly appreciates while the expansionary policy is in place. 200 100 6. Refer to the below diagram where T is tax revenues and ( is government expenditures. All figures are in billions of dollars. If the full-employment and actual GDP are each $400 billion. $100 200 300 400 500 600 700 800 GDP government can balance its budget by: government spending varies directly with GDP, but tax revenues are independent of GDP. tax revenues vary directly with GDP, but government spending is independent of GDP. tax revenues and government spending both vary directly with GDP. tax revenues and government spending both vary inversely with GDP. 3. Crowding out is a decrease in private investment caused by: a full-employment budget deficit. increasing T by $40 billion. an expansionary fiscal policy. increasing T by $10 billion and reducing G by $20 billion. the political business cycle. reducing I by $20 billion. a contractionary fiscal policy reducing ( by $20 billion.14. The federal government runs a budget deficit when: a) it buys back more bonds than it issues. b) it spends less than it receives in tax revenues. c) it spends more than it receives in tax revenues. d) the economy is growing rapidly. 15. The federal government runs a budget surplus when: a) it buys back more bonds than it issues. b) it spends less than it receives in tax revenues. c) it spends more than it receives in tax revenues. d) the economy is growing rapidly. 16. When the federal government runs a budget deficit: a) it borrows money from the public by issuing bonds. b) interest payments on the existing debt increase. c) transfer payments tend to increase. d) the total volume of the national debt decreases. 17. An increased federal budget deficit during a recession serves as an automatic economic stabilizer because: a) increased transfer payments from unemployment insurance partly offset the fall in household income. I b) lower personal income translates into lower tax load and so consumption spending declines slightly less. c) lower corporate profits translate into lower tax load and so investment spending declines slightly less. d) all of the above.18. An increased federal budget deficit during an expansion serves as an automatic economic stabilizer for all of the following reasons except: a) reduced transfer payments from welfare programs partly offset the overall increase in household income. b) higher personal income translates into a higher tax load and so consumption spending is slightly curbed. c) higher corporate profits translate into higher tax load and so investment spending is slightly curbed. d) the positive government saving stimulates consumption spending. 19. If an economy moves into a recession, causing that country to produce less than potential GDP, then: a) automatic stabilizers will cause tax revenue to decrease and government spending to increase. b) automatic stabilizers will cause tax revenue to increase and government spending to decrease. c) tax revenue and government spending will be higher because of automatic stabilizers. d) tax revenue and government spending will be lower because of automatic stabilizers. 20. If US economy moves into an expansion while producing more than potential GDP, then: a) government spending and tax revenue will increase because of automatic stabilizers. b) government spending and tax revenue will decrease because of automatic stabilizers. c) automatic stabilizers will increase government spending and decrease tax revenue. d) automatic stabilizers will decrease government spending and increase tax revenue