Problem Set 5 Answesr

Problem Set 5 Answesr - Economics 3213 Answers to Problem...

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Economics 3213 Answers to Problem Set 5: The Little Mermaid Prof. Xavier Sala-i-Martin 1. Flounder i. In this economy Bolivia is borrowing to sustain higher consumption today; the loan will be repaid with tomorrow's higher income. Japan instead is lending because it is richer today than will be tomorrow. Both countries are better off than if they were in isolation because they are able to smooth consumption intertemporally. This is not a contradiction with what we saw in class. In class we analyzed a closed economy, i.e. a country in isolation. Now we have two open economies. The condition that there is no net lending or borrowing in the economy as a whole applies here to the world as a whole. Total borrowing in the world must equal total lending in the world. Countries in this setting are analogous to individuals in class, and the world as a whole becomes a closed economy. ii. We know from class that in a two-period economy the budget constraint has a slope negative (1 + r ) that depends only on the interest rate. The budget constraint passes through the income point ( Y 1 , Y 2 ) because it is always feasible to consume current income without borrowing or lending. Diagram 1 shows the effect of an increase in Y 1 . The new budget constraint is parallel to the old one but is shifted to the right. This calls for an increase in consumption in both periods. Since overall lifetime income is higher, Bolivia is richer and can consume more. This has a positive wealth effect. There is no substitution effect because the interest rate is constant, and hence the price of today's consumption relative to saving and tomorrow's consumption is unchanged. However, consumption today increases by less than the increase in today's income due to a preference for consumption smoothing. Bolivians will borrow less today in order to pay less and consume more tomorrow.
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