Question

Flag Consider a two-period small open economy without production and a representative household, which lives for two periods. It receives endowments in the first period (Q1) and second period (Q2), respectively. The household inherits no wealth and optimally decides how much to consume in the first period (C1) and second period (C2) as well as international bond holdings (B1) in the first period, which pays the interest rate R. Household preferences are given by U(C1; C2) = log(C1)+log(C2). Explain in THREE sentences the effects of anticipated permanent improvement in terms of trade.

Answer 1

The budget constraints in the following situation will be

C1 + B1 = Q1 -------------------------- eq1

C2 = (1 + R)B1 + Q2 ------------------------- -eq2

From eq 1

B1 = Q1 - C1

C2 = (1+R) (Q1 - C1) + Q2

=> C1 + C2/(1+R) = Q1 + Q2/(1+R)

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With anticipated improvement in terms of trade, the opportunities for increase in income will lead to higher consumption possibilities in both the periods.

Higher investment opportunities to the consumers and higher rates of retuen on these investments. Higher return would mean more income available to the consumer for consumption in second periodThis would in turn lead to increase in standards of living of the consumer.

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