International Finance - Section 2

Richard Walker, Northwestern University

Consider the 2-country, 2-period model of intertemporal trade from class, with endogenous output levels. As
in class, each country takes the world interest rate r as given, and first chooses its stream of banana
production (Y1 , Y2 ) in order to maximise the present value thereof; it then borrows and/or lends in the
international capital markets to finance its preferred intertemporal consumption choice (c1 , c2 ). In the latter
stage each maximises the usual logarithmic utility function:

c2
Max ln [c1 ] + ln [c2 ] s.t c1 + E
1+r

Y2
where E = Y1 + 1+r . Each country has the same utility function, i.e. the same discount factor .

The IPPFs are implicitly described as follows. In each period a countrys overall productive capacity P is a
function of physical capital K:

P1 = F (K1 ) (1)
P2 = F (K2 ) (2)

where subscripts refer to the time period. So the USs period-1 productive capacity is equal to F (K1us ), where
K1us is the USs period-1 stock of physical capital; its period-2 productive capacity is the same function F (.)
of period-2 physical capital. The productive capacities of China in the two periods are described by exactly
the same function F (.), only with the physical capital stocks potentially differing from those of the US.

F
Some properties of the function F (K) are that: K > 0, so increased K leads to increased production;
2 F
K 2 < 0, so the marginal productivity of physical capital falls as K rises.

Each country takes its period-1 capital stock as given; it is inherited from history. However, for each country
the period-2 capital stock K2 is a choice variable, as now described. In the first period a country can allocate
its productive capacity P1 between output of consumption goods Y1 (bananas) and output of investment
goods I1 (banana factories). In the second period there is no point in producing investment goods, and so
each countrys entire productive capacity is devoted to the output of bananas. This is summarised by the
following equations:

1
 P1 = I1 + Y1 (3)
P2 = Y2 (4)

The benefit from allocating period-1 resources to investment rather than consumption goods is that this
increases the period-2 capital stock and thus period-2 banana output:

K2 = K1 + I1 (5)

Note period-1 investment must be nonnegative: I1 0.

(i) Use equations (1)-(5) to obtain the function describing the IPPF of each country. That is, write period-2
banana output Y2 in terms of period-1 banana output Y1 and the exogenous variable K1 . [Hint: this is simple
substitution; start with (4).]

(ii) Derive the first-order condition for optimal production (i.e. the equation for the tangency condition).

(iii) Draw the two countries IPPFs under the assumption that K1us > K1ch , so that the US inherits a larger
physical capital stock from history. Make sure to label the intercepts and to justify the shape of the two
IPPFs.

(iv) Maintaining the assumption that K1us > K1ch , prove that China will run a trade deficit in general
equilibrium. You may appeal to the result that the faster-growing country (in terms of banana output) will
run a trade deficit.