Department of Economics

Columbia University

Instructor: Martn Uribe

Spring 2013
Economics W4505
International Monetary Theory and Policy
Homework 4
Due February 20 in class

1. The Terms of Trade and the Current Account

Consider the following chart showing commodity prices in world markets:
Price
Period 1 Period2
1
1
1
2

Commodity
Wheat
Oil

In the table, prices of oil are expressed in dollars per barrel, prices of wheat are expressed in dollars
per bushel. Kuwait is a two-period economy that produces oil and consumes wheat. Consumers have
preferences described by the lifetime utility function
U (C1 , C2 ) = C1 C2 ,
where C1 and C2 denote, respectively, consumption of wheat in periods 1 and 2, measured in bushels.
Kuwaits per-capita endowments of oil are 5 barrels in each period. The country starts period 1 with
net financial assets carried over from period 0, including interest of 10 percent, worth 1.1 bushels of
wheat (i.e., (1 + r0 )B0 = 1.1). The interest rate in period 0 is assumed to be 10 percent (i.e., r0 = 0.1).
The country enjoys free capital mobility and the world interest rate is 10 percent. Financial assets are
denominated in units of wheat.
(a) What are the terms of trade faced by Kuwait in periods 1 and 2?
(b) Calculate consumption, the trade balance, the current account and national savings in periods 1
and 2.
(c) Answer the previous question assuming that the price of oil in the second period is not 2 but 1
dollar per barrel. Compare your answers to this and the previous question and provide intuition.
2. Capital controls. Consider a two-period model of a small open economy with a single good each
period and no investment. Let preferences of the representative household be described by the utility
function
p
p
U (C1 , C2 ) = C1 + C2
The parameter is known as the subjective discount factor. It measures the consumers degree of
impatience in the sense that the smaller is , the higher is the weight the consumer assigns to present
consumption relative to future consumption. Assume that = 1/1.1. The representative household
has initial net foreign wealth of (1 + r0 )B0 = 1, with r0 = 0.1, and is endowed with Q1 = 5 units of
goods in period 1 and Q2 = 10 units in period 2. The world interest rate paid on assets held from
period 1 to period 2, r , equals 10% (i.e., r = 0.1).
(a) Suppose that there is free international capital mobility. Calculate the equilibrium levels of
consumption in period 1, C1 , consumption in period 2, C2 , the trade balance in period 1, T B1 ,
and the current account balance in period 1, CA1 .
(b) Suppose now that the government imposes capital controls that require that the countrys net
foreign asset position at the end of period 1 be nonnegative (B1 0). Compute the equilibrium
value of the domestic interest rate, r1 , consumption in periods 1 and 2, and the trade and current
account balances in period 1.
1

(c) Evaluate the effect of capital controls on welfare. Specifically, find the level of utility under capital
controls and compare it to the level of utility obtained under free capital mobility.
(d) For this question and the next, suppose that the country experiences a temporary increase in the
endowment of period 1 to Q1 = 9, with period 2 endowment unchanged. Calculate the effect of
this output shock on C1 , C2 , T B1 , CA1 , and r1 in the case that capital is freely mobile across
countries.
(e) Finally, suppose that the capital controls described in part (b) are in place. Will they still be
binding (i.e., affect household behavior)?