Consider the intertemporal model with two time periods. Home is a small open economy that can borrow and lend in the first period at a fixed world real interest rate of r = 4%. In the first period output is Q0 = 800. Because of a recession, output in the second period output is expected to fall to Q1 = 500. The country wants to smooth consumption as much as possible. The country begins with no external assets or liabilities. Finally, assume that the intertemporal utility function at home is

u(c0) + u(c1) where = 1 , u is concave (i.e. consumers are risk averse and want to smooth consumption).

1+r (a) Solve for consumption, the current account, and financial account in the first period (t = 0).

(b) Solve for the trade balance, current account, and financial account in the second period (t = 1).

(c) Would Home be better off or worse off if the world interest rate is 1% instead of 4%? Explain using the appropriate equations.