Question

If, in an open economy with a real world interest rate of 5%, an output shock (decline) of 21% occurs followed by a recovery the next year:

no borrowing is possible because of the possibility of exceeding the long-run budget constraint.

no consumption smoothing is possible.

the nation can borrow 20% of GDP in the first year and repay 1% of GDP each year in perpetuity resulting in consumption smoothing.

the economy would have to terminate all international trade and financial flows.

Answer 1

The nation can borrow 20% of GDP in the first year and repay 1% of GDP each year in perpetuity resulting in consumption smoothing.

Hence (c) is correct option

Explanation

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