Two-Period Solow - International Finance Study of trade...

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1 The Two-Period Model Lecture 1 International Finance Study of trade over time. I give you a slip of paper today. You give me goods today. I give you goods in exchange for slip of paper tomorrow. Trade over time is no different from trade in apples and oranges today. All of our theories of comparative advantage etcetera, remain intact. Need new terminology to capture ideas. The slip of paper is a financial contract. The Financial Contract and Its Price The contract is an agreement between two parties. The contract specifies the amount of one good I must give up today in order to receive a certain (different) good tomorrow. Think apples today for oranges tomorrow. How much should I pay for the contract? There are two prices: The relative price of the two goods. How many apples would I trade for one orange if they were both in the market at the same time. The relative price between the two periods. How much do I have to pay to get extra consumption tomorrow in terms of consumption today. The Relative Price of the Two Goods Throughout our economics training we are accustomed to thinking of different prices for different goods. What determines the relative price of apples and oranges? How much do we like apples versus oranges? If we like apples a lot relative to oranges, they will tend to be more expensive. Are apples more readily available than oranges? If the supply of apples is high relative to oranges, they will tend to be cheaper. So, supply and demand determine the relative price of apples and oranges – fascinating. The Relative Price Between Two Periods The principal is the same: supply and demand determine the relative price of consumption today versus consumption tomorrow. How eager are we to consume? If we are very impatient (we want to eat now!), consumption today will tend to be more expensive. Are times good or bad today relative to the future? If there is lots of stuff to consume today (relative to tomorrow), today’s consumption will tend to be cheaper. So, there will be no difference in thinking about trade today versus trade tomorrow, except in terminology. To Be More Specific, We Need a Model The model is simply a representation of reality We cannot expect too much of it.
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