assumption in this question)
i. What about in later years? State the levels of CA, TB, NFIA, and FA in year 1 and
thereafter.
Answer: In subsequent years, the values are as follows:
5. Continuing from the previous question, we now consider Russia’s external wealth
position.
a. What is Russia’s external wealth W in year 0 and later? After a few years, the
world interest rate rises to 12%. In this case, can Russia continue its original plan?
What are the interest payments due on the debt if r* = 12%? If I = G = 0, what can
Russia do to meet those payments?
Answer: Russia borrows $20.77 billion in period 0. Its net external wealth
b. Suppose Russia decides to unilaterally default on its debt in this case. State the
levels of CA, TB, NFIA, and FA in all subsequent years. What happens to the
Russia’s level of C in this case?
Answer: Assume Russia defaults in period 3. The table on the next page shows
c. When the default occurs, what is the change in Russia’s external wealth W? What
happens in the rest of the world’s (ROW’s) external wealth?
Answer: If Russia defaults on this debt, NFIA = 0 because external wealth rises to
d. Suppose that foreign investors, wanting to prevent Russia’s default, offer to
forgive some of its debt. How much debt would have to be forgiven to allow
Russia to keep its consumption smooth at the level found in the previous
question? Why might investors agree to do this?
Answer: To prevent the default and allow Russia to enjoy the level of
consumption it had in year 0, investors will have to forgive the added $1.66 in
e. How would you expect investors to react to Russia’s future attempts to secure
financing for its investment projects? How is this related to the concept of risk
premium?
Answer: Whether Russia defaults or is offered debt forgiveness, this will damage
its ability to secure financing for future investment projects. It is likely that
Russia
defaults in
period 3
Period
Variable
0
. . .
Present
value
r*
MPK
Output GDP
Q
300.00
. . .
7,840.0
0
4%
8%
Expenditure
GNE
C
300.77
. . .
7,820.0
0
+I
20.00
20.00
Trade
balance
TB
−20.77
. . .
−19.20
Current
. . .
6. Consider a country that experiences a positive, one-time shock to its output. Assume
that output is initially $1,200 per year and the world real interest rate is 6%. In year 0,
output increases by 20%, after which it returns to its initial level.
a. Calculate the present value of output in this economy.
Answer: There is a one–time increase in output of $240 (= 1,200 × 0.20).
b. Assume the economy is a closed economy. Calculate the present value of
consumption and level of consumption each period, assuming the country engages
in consumption smoothing.
Answer: The present value of consumption is
c. Assume the economy is an open economy. Calculate the present value of
consumption and the level of consumption each period, assuming the country
engages in consumption smoothing.
Answer: In the open economy, the present value of consumption is the same as in
the closed economy. The difference is that the country is able to save the gain in
d. For the open economy, calculate TB, NFIA, and TB in year 0. What happens to
this country’s external wealth in period 0?
Answer: In year 0, the values are as follows:
e. For the open economy, calculate TB, NFIA, and TB in subsequent years. What
happens to this country’s external wealth in period 0?
Answer: In subsequent years, the values are as follows:
f. How would your previous answers differ if the shock were a permanent increase
in output? Explain.
Answer: If the country experiences a permanent increase in output, then it will
7. The Association of Southeast Asian Nations (ASEAN) is a political and economic
association similar to the European Union (EU). Its membership includes several
countries such as Indonesia, Malaysia, Singapore, and Thailand, but does not include
the region’s largest economies, such as Japan. ASEAN members have access to a
free–trade area. Proposals to expand the ASEAN free–trade area to include Japan and
China have met opposition. Explain why countries with lower standards of living
(such as those recently admitted) are more likely to seek membership in ASEAN and
identify which countries stand to lose from ASEAN’s expansion. Consider the
importance of capital flows for living standards, using the production function
approach.
Answer: Poorer countries will seek access to free–trade areas to encourage capital
inflow from abroad. These agreements often impose financial openness and
8. Using the production function approach (augmented model), answer the following
questions. For simplicity, assume that there are two countries: a poor country (with
low living standards) and a rich country (with high living standards). Explain and
illustrate how convergence works in the following cases. Briefly explain how each
scenario affects the speed with which the poor country converges with the rich
country. Unless otherwise noted, assume each country has the same MPK and that
their productivity levels are different, with AP < AR.
a. Foreign direct investment into the poor country leads to an increase in its access
to technology.
Answer: See the diagrams on the next page. Because MPK is higher in the poor
b. The rich country experiences an increase in human capital through government
funding of education.
Answer: See the diagrams on the next page. The increase in education causes an
c. The poor country experiences an improvement in political stability through the
signing of a peace treaty between warring factions.
Answer: See the diagrams on the next page. The productivity level in the poor
d. A sovereign debt default by the poor country’s government leads to an increase in
the risk premium.
Answer: The existence of the risk premium drives a wedge between the MPK in
9. Use the production function approach to examine Bolivia and Chile. Assume that
Bolivia and Chile have different production functions, q = f(k), where q is output per
worker and k is capital per worker. Let q = Ak1/4. Assume A in Bolivia is lower than A
in Chile.
a. Draw a production function diagram (with output, q, as a function of capital, k)
and MPK diagram (MPK vs. k) for Chile. (Hint: Be sure to draw the two diagrams
with the production function directly above the MPK diagram so that the level of
capital, k, is consistent on your two diagrams.)
Answer: See the following diagrams.
b. On the same diagrams, plot Bolivia’s production function and MPK curves,
assuming Bolivia’s MPK currently exceeds Chile’s MPK. Label Chile’s position
in each graph point A. Similarly, label Bolivia’s position point B.
Answer: See the previous diagrams.
c. Assume capital is free to flow between Chile and Bolivia (and the rest of the
world) and that Chile is already at the point where MPK = r*. Label r* on the
vertical axis of the MPK diagram. Assume no risk premium. Where does
Bolivia’s capital converge? Label this outcome point C in each diagram. Will
Bolivia’s level of output per worker converge with that of Chile’s? Explain why
or why not.
Answer: No, Bolivia’s output per worker is lower than Chile’s because its
d. How would the existence of a risk premium (required by investors for Bolivian
capital investment projects) affect your answer to (c)?
Answer: The existence of a risk premium would widen the gap between Bolivia
e. Describe two government policies that Bolivia could implement to improve the
convergence process.
Answer: The government can promote programs designed to increase the
10. In this chapter, we saw that financial market integration is necessary for countries to
smooth consumption through borrowing and lending. Consider two economies,
Albania and Austria. Both are former Communist–bloc countries that have pursued
policies to privatize businesses and open financial markets. However, Austria began
this process roughly 10 years earlier than Albania. For each of the following shocks,
explain how and to what extent each country can use diversification to smooth
consumption.
a. Floods in Austria destroy a portion of the capital stock.
Answer: This is a negative idiosyncratic shock to Austria. Austria continues to
b. Albania experiences an influx of labor from the former Yugoslavia during the war
in Kosovo.
Answer: This is an idiosyncratic positive shock to Albania’s output from the
c. Both Albania and Austria experience a decrease in exports because of a recession
in Italy.
Answer: This is an example of a common shock. Albania and Austria would be
11. The production function approach suggests that countries should experience
convergence in the levels of output per worker through the flow of capital across
countries. One possible problem with the production function approach is the
assumption that countries have the same capital shares. Poorer countries may have
lower shares of income earned from capital relative to those in richer countries. Based
on this information, discuss the implications of differences in capital income share in
rich versus poor countries for diversification. Are poor countries in a better position
to engage in risk sharing with high capital income shares or low ones? Explain.
Answer: If poor countries have a lower capital income share, this will limit their
ability to diversify away idiosyncratic risk. Because equity in labor income cannot be