Suppose that there is a small country named A in the world. However, there is a king in the country A, who does not allow households in the country to trade in international financial markets. Households in country A are risk-averse with a period utility function of u(ct) = ln(ct). Time runs for two periods: t=1,2. The country A receives an income (endowment) at each period, denoted by Y1A and Y2A. The time discount factor of households in country A, is one. B0A = 0.

(10 points) Y1A = 1, Y2A = 1.2. What is consumption at each period, cA1 , cA2 . What are the trade balance and current account (TB1 and CA1) at period 1 in this economy?

(10 points) Now, the king has died, and the households in the country A decided to open the country to international financial markets in which they can trade bond B1 at period 1. Which world interest rate r1 makes households in this economy smooth their consumption perfectly? (i.e., cA1 = cA2 )

(10 points) Compute TB1,TB2 and CA1,CA2 at the interest rate r1, at which households smooth their consumption perfectly.

(10 points) Let r1 be 0.1. Compute CA1. Now Y2A is expected to decrease from 1.2 to 1.0. Does CA1 increases or not after this change? Provide your intuition for your answer.