Consider the inter-temporal model with two time periods t = 0 and 1. Home is a small open economy that can borrow and lend in the first period at a fixed world real interest rate of 7% (.07). In the first period output is X0= 600. Because of a robust investment environment, output in the second period is expected to rise to X1= 800. The country wants to smooth consumption as much as possible. The country begins with no external assets or liabilities.

a) Solve for the optimal level of consumption consistent with perfect consumption smoothing, the current account, and financial account in the first period (t = 0).

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

c) Explain the intuition as to why the CA and TB is different in period 1.

d) Draw a graph, completely labeled with indifference curves depicting clearly that Home is better off when they have access to international financial markets as compared to being a closed economy. In particular, label the indifference curve under a closed economy assumption as ICclosedand the indifference curve under an open economy assumption as ICopen