This document contains a set of questions for practise for the exam. This document is very helpful to achieve a high mark in the EC312 end of year exam.
2019 Mid term Q3
According to balance of payments accounting, a transaction that appears in the current account gives rise to an
offsetting transaction in the capital account
FALSE:
Whilst it is true that the Balance of Payments must be maintained at a net of zero, the capital and current accounts do
not offset eachother intentionally. Given the capital account deals wigth financial assets and the current account
considers goods and services, we do not observe simultaneous offsetting effects if one of them makes a move. Instead,
a rise or fall in the current account would lead to something from the financial account offsetting, so the balance of
payments can still remain at zero, but by no contribution of the capital account. For example, if someone was to
purchase a foreign car as an import, that would lead to a decline in the current account, but this would be offset by the
financial value of the car appearing as a positive value in the financial account.
,Intertemporal Consumption
2022 Mid-term Q3
In the two-period model of the intertemporal approach to the current account (without government
expenditure or investment), if the subjective discount factor that measures the impatience to consume is
larger than the intertemporal relative price, it is optimal to consume more in the first than in the second
period.
FALSE:
When you are deriving optimal consumption, you get the following first order condition:
' '
U ( C1 ) =β ( 1+r ) u ( C2 )
1
This means that if the subjective discount factor ( β= ) is bigger than the intertemporal price, β (1+ r )<1
1+r
which implies that you get less utility from an additional unit of consumption in period 1 compared to an
additional unit of consumption in period 2. As a result the statement is false, meaning that if the subjective
discount factor is larger than the intertemporal price, it is more optimal to consume more in period 2.
2016 Q4:
Consider the two-period model of the intertemporal approach to the current account. Assume that a small
economy Home consumes a single good and has endowments equal to Y1=3𝑌̅ in period 1 and Y2=𝑌̅ in
period 2. The representative consumer maximizes:
U=log(C1)+βlog(C2)
where C1 and C2 are the consumption levels in periods 1 and 2, respectively, and β is the subjective discount
factor. The real interest rate for borrowing or lending on world capital markets r is given.
(a) Write down the intertemporal budget constraint and the maximization problem of the representative
consumer. Derive the Euler equation. (13 marks)
(b) Derive the consumption levels C1 and C2 as a function of r, β, and 𝑌̅. (13 marks)
(c) Assume there is a Foreign country where the representative consumer maximizes U*=log(C*1)+βlog(C*2)
where C*1 and C*2 are the foreign consumption levels and Y1* =𝑌̅ and Y*2=3𝑌̅ are the endowments in periods
1 and 2, respectively. Derive the consumption levels C*1 and C*2 as a function of r, β, and 𝑌̅. (13 marks)
(d) Compute the autarky interest rates for both the Home and Foreign economy. (13 marks)
2018 Q2:
Consider the model of the intertemporal approach to the current account (without investment). Suppose
the country has a current account surplus in period 1. Using a two-period graph, with indifference curves
and a budget line, indicate the point where the economy is in equilibrium. Explain why this particular point
is chosen. (16 marks)
In the intertemporal model, we look a 2-period model of consumption. The key assumption is that there is
an endowment economy where only one single good is consumed, with a representative household, or in
other words everyone is acting the same. Consumers can either consume in period one or two, and can
,borrow or lend with a given interest rate r. Given output, y, is perishable, all must be consumed by the end
of the second period and there is perfect foresight about the future.
In this model, as the graph shows, the solution to the optimal consumption within
the two periods comes from deriving the Euler equation. If we assume the
representative household has the utility function of U =u ( C1 ) + βu(C2 ), and a
C Y
intertemporal budget constraint of C 1+ 2 =Y 1 + 2 where C and Y are
1+r 1+ r
consumption and endowments in the respective periods, we can find the following
equation for optimal consumption:
u' ( C1 ) =β ( 1+r ) u '(C 2)
This is the Euler equation. The Euler equation informs about the relative consumption between periods one
and two. If intertemporal marginal rate of substitution (the beta) is equal to the intertemporal relative
price, consumption in both periods should be the same. However, the higher the beta, the more
consumption we should see in period 2. Graphically, the optimal point is noted at the tangential point
¿ ¿
( C 1 , C 2 ). The reason this is the point selected as it provides optimal utility for the household given their
utility function and intertemporal relative price throughout the two periods. As a result, this will be where
the economy is in equilibrium.
Given the economy is in a current account surplus in period 1, we know that they are not consuming the
full endowment in period 1 in equilibrium. This is why, graphically, we see Y 2 to be less than the optimal
level of consumption in period 2 as the representative household has saved more from period 1 and
exported some of the endowment, in order to be able to consume more in period 2. From this, when
referring to the Euler equation, we know that the beta must be higher relative to the intertemporal relative
price or, in other words, β (1+ r )< 1.
In the intertemporal approach to the current account, one assumes that the economy
is small and exists in a two-period endowment economy. The consumer’s utility
function is concave and diminishing in marginal utility. If a country runs a surplus in
period 1, it must be the case that in period 2 they run a deficit. This can be shown in
the graphs below. This is because of the assumption of a two period economy.
Countries can’t bring any net foreign assets from the past, so in the first period B =0.
By the end of the second period, it must be
such that B also =0 since it is not optimal for
the country to be left with any foreign assets as
they will not exist in period 3. This means that if
a country runs a surplus in period 1 and
acquires foreign assets, it must use these in
period 2 and run a deficit as to satisfy the above
conditions.
2019 Q3:
Consider the model of the intertemporal approach to the current account (without investment or public
expenditure). Suppose the country has a current account surplus in period 1. The country is then hit by a
transitory shock to the endowment in period 1 such that Y1 rises. In a two-period graph, indicate the point
where the economy will move after the transitory shock. Explain what happens to the trade balance. (16
marks)
, If you are already running a current account surplus in period 1
and your endowment increases in the first period, the trade
balance will improve. This is because if with the endowment
increasing, you will save some of it to smooth consumption, and
so therefore will opt to lend more (in absolute terms) in the first
period, meaning your trade balance will improve. The new
equilibrium will be where IC2 intersects the shifted budget line
tangentially. The reason the budget line shifts out is as a result of
the increased total endowment and so therefore the indifference
curve will increase due to the increased consumption.
The intertemporal approach to the current account
assumes that countries are small and exist in a two-period endowment
economy. Consumers have a utility function that is concave with diminishing
marginal utility.
If in period 1, the country is hit with a temporary shock that increases the
endowment in period 1, consumption in period 1 increases. This is because
consumers want to smooth their consumption across periods. Hence,
consumption increases, but not as much as the change in endowment.
This is because consumers save some of the increase to spend in the next
period. In period 1 then, the trade balances improves (increase in endowment >
increase in consumption), but in period 2 it worsens (the endowment stays the same
but consumption increases). This can be shown in the diagram below, where the
economy moves to point A.
2020 Q4:
Consider the two-period model of the intertemporal approach to the current account. Assume that a small
economy Home consumes a single good and has endowments equal to Y1=3Y in period 1 and Y2=Y in
period 2. The representative consumer maximizes:
U=log(C1)+βlog(C2)
where C1 and C2 are the consumption levels in periods 1 and 2, respectively, and β is the subjective
discount factor. The real interest rate for borrowing or lending on world capital markets r is given.
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