Consider two countries that have access to international capital market but face drastically different real interest rates. In particular, country A can borrow or lend as much as it wants at a real rate equal to 5% (.05). Country B on the other hand faces a real rate equal to 40% (.40).
a) (10 points) Explain why we would expect that more often than not, different countries face different real rates of interest in international capital markets. Be specific as in applying your reasoning to this particular case… that is, why would country A face such a drastically lower real interest rate relative to country B. Please refer to the real world as much as possible. What countries in the real world might be country A, what countries in the real world might be country B and why.
b) (10 points ) Both countries have identical GDP’s in the current period = 0 and expect to have the identical GDP’s next period. The information is below:
Country A: GDP in period 0 = 1200, GDP (expected) in period 1 = 1200, r = .05
Country B: GDP in period 0 = 1200, GDP (expected) in period 1 = 1200, r = .40
Each country prefers to perfectly smooth consumption = GDP. Each country has an investment opportunity that would cost 40 in current consumption = GDP but returns 50 in additional GDP = consumption in the next period = period 1. Do the math and determine whether the investment project will make country A, country B, better off, worse off, or no change in utility.
c) (20 points – 10 for each correct and completely labeled diagram) Now depict your results on two separate two period consumption diagrams. Please put the results for country A on left hand side and the results for country B on the right hand side. Be sure to clearly indicate, via indifference curves, the level of utility with investment and the level of utility without investment for both countries.
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