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?

2

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

# 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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