EPFL Prof.

Luisa Lambertini
College of Management of Technology Office: 2.05 ODY
Fall 2016 E-mail: luisa.lambertini@epfl.ch
Macrofinance, MFE http://moodle.epfl.ch/course/view.php?id=6261

Solution to Problem Set #4

due Wednesday November 15, 2017

1. Consider a two-period endowment small-open economy. The representative agent has

preferences described by the utility function
1− σ1 1− 1
C C σ
U= 1 1 + 2 1, σ > 0, (1)
1− σ
1− σ
where C1 , C2 denote consumption in period 1 and 2, respectively. The endowments are
Y1 and Y2 in period 1 and 2, respectively. Let Y1 = 10, Y2 = 16.9, σ = 2.
(a) Find the autarky interest rate ra .
Answer: The gross interest rate equals the marginal rate of subsitution between
period 1 and 2: r r
C2 Y2
= = (1 + r), → ra = 0.3.
C1 Y1
(b) Suppose the economy gets access to international financial markets where it can
freely borrow and lend at the interest rate r = 0.1. Solve for the equilibrium levels
of C1 and C2 and the current account at the end of period 1, CA1 . In a diagram
with C1 on the horizontal axis and C2 on the vertical axis show the equilibrium
allocation under autarky and under intertemporal trade, indicating the current
account. Calculate the welfare gain of access to financial markets.
Answer: The FOC consist of the Euler equation and the intertemporal budget
constraint:
−1 −1
C1 2 = (1 + r)C2 2
C2 Y2
C1 + = Y1 +
1+r 1+r
Solving the Euler equation for C2 gives

C2 = (1 + r)2 C1 ,

and inserting into the IBC gives

Y2
C1 (1 + (1 + r)) = Y1 + .
1+r

1
 Solving for C1 and inserting the values for r, Y1 and Y2 yields C1 = 12.078, and
C2 = 14.614. The current account is

CA1 = Y1 − C1 = −2.078.

To calculate the welfare gain, we look at the difference in terms of lifetime utility
U in financial autarky and under free trade. Welfare under autarky is:

Y10 .5 Y20 .5
Ua = + = 14.546
0.5 0.5

Welfare under free trade is:

C10 .5 C20 .5
U ft = + = 14.596
0.5 0.5

So the welfare gain is:

∆U = U f t − U a = 0.05

Diagram:

(c) Assume now that the endowment in period 2, Y2 , is expected to fall from 16.9 to
12. Calculate the effect of this anticipated output reduction on consumption and
the current account.
Answer: C1 = 9.957, C2 = 12.047, CA1 = 0.043.

2
(d) Suppose now that the government imposes capital controls such that only the
fraction ψ of agents has access to international financial markets (and therefore
to borrowing/lending at the rate r) while the fraction 1 − ψ of agents remains
in autarky. Let ψ = 0.5. Calculate aggregate period-1 consumption, period-
2 consumption and the current account with Y2 as in (a-b) and in (c). Does
aggregate period-2 consumption fall more under full access to capital markets or
under capital controls? Please provide some intuition for your findings.
Answer: Aggregate consumption will is weighted average of those agents having
access to international financial markets, and those lacking such access, with the
weights being ψ and 1 − ψ. We have already calculated the consumption of either
of these two groups (in (b) and (c) for the first group, in (a) for the second group).
Aggregate consumption will the be
• With Y2 as in (a-b): C1 = 0.5 ∗ 10 + 0.5 ∗ 12.078 = 11.0390, C2 = 0.5 ∗ 16.9 +
0.5 ∗ 14.614 = 15.757, CA1 = −1.0390.
• With Y2 as in (c): C1 = 9.978, C2 = 12.024, CA1 = 0.022.
In (c), we saw that C2 falls when Y2 falls. But C1 also fell, i.e. the agents smooth
out the impact of the drop of endowment across all periods. Capital controls
hamper this smoothing behavior and aggregate C2 falls more: C2 falls by 23.7%
under capital control, whereas it falls by 17.6% under free trade.
(e) Suppose now that the endowment in period 2 is uncertain. With probability π(1)
period-2 endowment is Y2 (1) = 16.9; with probability π(2), Y2 (2) = 12. There is
no uncertainty in period 1 and Y1 = 10. Let π(1) = π(2) = 0.5. Calculate the
autarky interest rate and autarky prices for Arrow-Debreu securities that can be
purchased in period 1 at price p(s)a /(1 + ra ) and pay one unit of consumption in
period 2 if state s realizes. Calculate the variance of C2 .
Answer: The Euler equation under uncertainty states the expected marginal
rate of substitution equals the gross interest rate:

a u0 (C1 )
1+r =
Eu0 (C2 )
q
1
a 10
1+r = q q
1 1
0.5 16.9 + 0.5 12
1 + ra = 1.189
To calculate the Arrow-Debreu security prices, we can use the FOC:
s
Y1
p(s) = (1 + ra )π(s)
Y2 (s)

Inserting the values gives p(1)a = 0.457 and p(2)a = 0.543. The variance of con-
sumption in period 2 is :

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 V ar(C2 ) = V ar(Y2 ) = π(1)Y2 (1)2 + π(2)Y2 (2)2 − E(Y2 )2
= 0.5 ∗ 16.92 + 0.5 ∗ 122 − (0.5 ∗ (16.9 + 12))2 = 6.0025

(f) Following up on (e), suppose that all agents in the small-open economy get ac-
cess to financial markets where they can borrow and lend at the riskless rate
r = 0.1 and purchase Arrow-Debreu securities in period 1 at the price p(s)/(1 +
r). Suppose Arrow-Debreu securities are actuarially fair. Calculate equilibrium
C1 , C2 (1), C2 (2) and CA1 . What is the variance of C2 ? Compare your findings
here with those in (e) and provide some intuition.
Answer: Since AD securities are actuarially fair, p(1) = 0.5, p(2) = 0.5. We have
the following three FOC:
π(1) 0
u0 (C1 ) = (1 + r) u (C2 (1))
p(1)
π(2) 0
u0 (C1 ) = (1 + r) u (C2 (2))
p(2)
P P
s p(s)Y2 (s) p(s)C2 (s)
Y1 + = C1 + s ,
1+r 1+r
which we can solve for C1 , C2 (1) and C2 (2). Note that the first two conditions
imply that C1 (1) = C2 (2) ≡ C2 because p(s) = π(s). Solving for C2 gives
C2 = (1 + r)2 C1 ,
and inserting into the IBC gives
0.5 ∗ 12 + 0.5 ∗ 16.9
C1 (1 + (1 + r)) = 10 + .
1+r
Solving gives C1 = 11.02, C2 (1) = C2 (2) = 13.33, and CA1 = Y1 − C1 = −1.02.
The variance of C2 is zero because of perfect smoothing across states. Complete
markets ensure a lower volatility of consumption.
(g) Suppose that the government imposes capital controls so that only the fraction
ψ = 0.5 of agents in the small open economy have access to complete financial
markets; the other fraction 1 − ψ cannot trade at all and remains in autarky.
Calculate the variance of C2 and comment on your findings.
Answer: We know that the agents with access to complete markets will choose
a constant consumption level in period 2 of 13.33. The other agents will choose
16.9 in state 1 and 12 in state 2. Then aggregate consumption is C2 (1) = 15.12
and C2 (2) = 12.67. It results E1 [C2 ] = 13.89, V ar1 [C2 ] = 1.5. The variance of C2
is higher than under complete market because half the population has no access
to financial instruments and cannot smooth consumption. On the other hand,
the variance is lower than under autarky.