Consider the case of a home country where under normal conditions the level of GDP is Q=1000

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Question:

Consider the case of a home country where under normal conditions the level of GDP is Q=1000 and consumption C=1000 and I=G=0. Initially, these conditions are expected to last forever.

The world interest rate is r*=0.05=5%. Assume it is now time 0, and that external wealth at the end of all previous period was zero.

At time 0, under this scenario [1]:
What is the present value of output? PV(Q) = _____________ What is the present value of consumption? PV(C) = _____________

Now suppose conditions have changed, and the country has learned of a negative output shock at time t=0.

This shock is expected to last one year, and will lead to an output drop of 210 units. That is, GDP at time 0 falls to Q0 = 790, then returns to 1000.

At time 0, under this scenario [1]:

What is the present value of output? PV(Q) = _____________

What is the present value of consumption? PV(C) = _____________

Assume forward-looking agents desire smooth consumption over time.

Compute the new planned levels of consumption at t = 0 and 1 under this scenario. [1]

C0 = _____________ C1 = _____________

Compute the trade balance, NFIA, current account, and wealth at t = 0 and 1 under this scenario. [1]

TB0 = ___________ NFIA0 = ____________ CA0 = ______________ W0 = ______________ TB1 = ___________ NFIA1 = ____________ CA1 = ______________ W1 = ______________

Suppose period 0 ends as above. Now it is time 1, and suppose conditions have changed again, and the country learns of an identical negative output shock at time t=1. This shock is expected to last one year, and will lead to another output drop of 210 units. That is, GDP at time 1 falls to Q1 = 790, instead of 1000.

Compute the new planned levels of consumption at t = 0, 1, 2 under this scenario building on what has already happened in t=0. [1]

C0 = _____________ C1 = _____________ C2 = _____________

Compute the trade balance, NFIA, current account, and wealth at t = 0, 1, 2 under this scenario building on what has already happened in t=0. [1]

TB0 = ___________ TB1 = ___________ TB2 = ___________

NFIA0 = ____________ NFIA1 = ____________ NFIA2 = ____________

CA0 = ______________ CA1 = ______________ CA2 = ______________

W0 = ______________ W1 = ______________ W2 = ______________

d. Now return to that initial situation at t=0. Now suppose agents had learned at time t=0 that output was going to be at the level of 790 in both years 1 and 2, instead of 1000.

At time 0, under this scenario:

What is the present value of output? [1] PV(Q) = _____________

What is the present value of consumption? [1] PV(C) = _____________

How would planned levels of consumption differ here from the previous case where agents only learned in each year about the output drop in that year? [2]