International Finance - Section 1 with answers

Richard Walker, Northwestern University

1. Consider the model of intertemporal trade developed in lectures, i.e. the two-country, two-period model
with logarithmic utility. Assume that the output streams of America and China are exogenous: America
produces Y1A of bananas in period 1 and Y2A in period 2, while China produces Y1C in period 1 and Y2C in
period 2. Note that, unlike in lectures, we are not placing any numerical values on the output variables.

(i) Using the solutions to the individual consumption decisions, write the period-1 American trade balance in
terms of Y1A , Y2A , the intertemporal discount factor and the interest rate r.

Solving Americas utility maximisation problem (subject to its intertemporal budget

constraint) yields:
1
cA
1 = EA
1+
Y2A
 
1 A
= Y1 +
1+ 1+r

Americas trade balance is simply the difference between its output and its consumption in
period 1:

1 Y2A
Y1A cA
1 = Y1A
1+ 1+1+r

(ii) Solve for the equilibrium world interest rate r in terms of and the output variables Y1A , Y2A , Y1C and
Y2C .

Using the period-1 aggregate resource constraint, equating global banana supply to Chinese
and American demand:

Y1A + Y1C = cA C
1 + c1
Y A + Y2C
 
1
= Y1A + Y1C + 2
1+ 1+r
Y2A + Y2C
(1 + r) =
Y1A + Y1C

with r implicitly defined by the last equation, so that (1 + r) is equal to the ratio of global
banana output in period 1 to global output in period 2. Put another way, (1 + r) = 1 + g, where
g is the global growth rate of output.

1
(iii) Use the answer to (ii) to write the American trade balance in terms of the output variables and .

Y1A cA A C
1 = Y1 c1
YA
 
1
= Y1A Y1A + 2
1+ 1+r
Y + Y1C
A
 

= Y1A Y2A 1A
1+ Y2 + Y2C

(iv) What must be true of the dynamic output streams of America and China if the former is to be running a
period-1 trade deficit?

An American trade deficit is where Y1A < cA

1 ; using previous answer, this is the case if:

Y2A Y A + Y2C
A
> 2A
Y1 Y1 + Y1C

i.e. if the American growth rate exceeds the global growth of rate of banana production. If this
is to be the case, the American growth must necessarily exceed the Chinese growth rate.

So, an important result: at least in our simple model (with logarithmic utility, exogenous
output endowments, etc), America will run a trade deficit with China if it expects to grow more
quickly, regardless of the absolute levels of the respective outputs.