University of Warwick
EC312 – International Economics
Autumn 2015 – Natalie Chen
Problem Set 1
Exercise 1 (Exercise 5, Chapter 13, Krugman, Obstfeld and Melitz, reprinted here).
The nation of Pecunia had a current account de…cit of $1 billion and a non-reserve …nancial
account surplus of $500 million in 2002.
a) What was the balance of payments of Pecunia in that year? What happened to the country’s
net foreign assets?
b) Assume that foreign central banks neither buy nor sell Pecunian assets. How did the Pecunian
central bank’s foreign reserves change in 2002? How would this o¢cial intervention show up in
the balance of payments accounts of Pecunia?
c) How would your answer to b) change if you learned that foreign central banks had purchased
$600 million of Pecunian assets in 2002? How would these o¢cial purchases enter foreign balance
of payments accounts?
d) Draw up the Pecunian balance of payments accounts for 2002 under the assumption that the
event described in c) occurred in that year.
Exercise 2
Consider the two-period small open economy model presented during the lectures. This economy
consumes a single good and has endowments equal to 1 in period  = 1 and 2 in period  = 2.
The representative consumer maximises:
 =  (1 ) +  (2 )
where 1 and 2 are the consumption levels in periods 1 and 2 respectively,  is the subjective
discount factor, and  ( ) = 2 ¡ 2 2 , where  denotes the two di¤erent periods,  = 1 2.
The real interest rate for borrowing or lending on world capital markets  is given. Assume that
1
 = 1+
.
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a) Assume that 1 =  and 2 = 2 . Write down the intertemporal budget constraint of the
representative consumer and solve her maximisation problem. Derive the consumption levels 1
and 2 as a function of  and  .
b) Find the expression for the autarky interest rate for this economy. Is it greater or smaller
than the world interest rate ? What is the comparative advantage of this small open economy,
i.e. will this economy run a current account de…cit or surplus in period 1?
c) Now assume that in this economy there is a government which runs a balanced budget in
both periods, i.e.  =  for  = 1 2 where  denotes government spending and  are net
taxes. What happens to the level of consumption and to the current account 1 in period 1
when 1 = 0 and 2 =  ?
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