In answering this question, assume that there are no valuation changes of assets, that
the net international compensation to employees equals zero and that there are no net
unilateral transfers.
Consider a three-period economy that at the beginning of period 1 has a net foreign
asset position of −175. In each of the three periods 1, 2 and 3, GDP is 200. The interest
rate on bonds held between any two consecutive periods is 6 percent; that is, r0 = r1 =
r2 = r = 0.06.
(a) (4 marks) For this part of the question only, assume that in period 1, the economy
runs a current account deficit of 5 percent of GDP. Find the trade balance in period 1
(T B1), the current account balance in period 1 (CA1), and the country’s net foreign
asset position at the beginning of period 2 (B1).
(b) (1 mark) State the transversality condition for this economy.
(c) (4 marks) For this part of the question only, assume that in period 1, the economy runs
a current account deficit of 5 percent of GDP and that in period 2, the trade balance
of the economy is zero, that is, T B2 = 0. Is the economy living beyond its means?
To answer this question find the economy’s current account balance in period 3 and
the trade balance in period 3. Is this value for the trade balance feasible?
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ECON 7520 SEMESTER 1, 2023
(d) (5 marks) Compute as a percentage of GDP the maximal current account deficit in
period 1 that is feasible for the economy