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International Macroeconomics 3Rd Edition Feenstra Solutions Manual Full Chapter PDF
International Macroeconomics 3Rd Edition Feenstra Solutions Manual Full Chapter PDF
1. Using the notation from the text, answer the following questions. You may assume
that net labor income from abroad is zero, there are no capital gains on external
wealth, and there are no unilateral transfers.
a. Express the change in external wealth (W0) at the end of period 0 as a func-
tion of the economy’s trade balance (TB), the real interest rate (a constant, r*),
and initial external wealth (W1).
Answer: The total amount added to (or subtracted from) external wealth is equal
to the trade balance plus interest earned on external wealth from the previous
period: W0 TB0 r*W1.
b. Using (a), write an expression for the stock of external wealth at the end of pe-
riod 0 (W0). This should be written as a function of the economy’s trade balance
(TB0), the real interest rate, and initial external wealth (W1).
Answer: Rewriting the previous expression, solving for W0:
W0 W0 W1 TB0 r*W1
W0 TB0 (1 r*)W1
c. Using (a) and (b), write an expression for the stock of external wealth at the end
of period 1 (W1).This should be written as a function of the economy’s trade bal-
ance (TB) each period, the real interest rate, and initial external wealth (W1).
Answer: From (a), we know that the change in wealth in period 1 is equal to
the trade balance in period 1 plus interest earned on external wealth from pe-
riod 0:
W1 TB1 r*W0
Rewriting this expression to solve for W1:
W1 TB1 (1 r*)W0
Plugging in the expression from (b) for W0:
W1 TB1 (1 r*)[TB0 (1 r*)W1]
W1 TB1 (1 r*)TB0 (1 r*)2W1
S-43
S-44 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization
d. Using your answers from (a), (b), and (c), write an expression for the stock of ex-
ternal wealth at the end of period 2 (W2). This should be written as a function
of the economy’s trade balance (TB) each period, the real interest rate, and ini-
tial external wealth (W1).
Answer: Using the same method from (c) to solve for W2:
W2 TB2 r*W1
W2 TB2 (1 r*)W1
W2 TB2 (1 r*)[TB1 (1 r*)TB0 (1 r*)2W1]
W2 TB2 (1 r*)TB1 (1 r*)2TB0 (1 r*)3W1
e. Suppose we require that W2 equal 0. Write down the condition that the three
trade balances (in periods 0, 1, and 2) must satisfy. Arrange the terms in present
value form.
Answer: If W2 0, then
TB2 (1 r*)TB1 (1 r*)2TB0 (1 r*)3W1 0
(1 r*)3W1 TB2 (1 r*)TB1 (1 r*)2TB0
In present value terms:
TB1 TB2
(1 r*)W1 TB0
(1 r*) 2
(1 r*)
2. Using the assumptions and answers from the previous question, complete the following:
a. Write an expression for the future value of the stock of external wealth in period
N (WN).This should be written as a function of the economy’s trade balance (TB)
each period, the real interest rate r*, and initial external wealth.
Answer: The future value of external wealth in period N is the sum of the trade
balance in each period (compounded by the interest earned or paid) plus com-
pounded interest earned on initial external wealth:
WN TBN (1 r*)TBN1 (1 r*)2TBN2 . . . (1 r*)N TB0
(1 r*)N1W1
b. Using the answer from (a), write an expression for present value of the stock of
external wealth in period N (WN).
Answer: In present value terms, divide both sides of the previous expression by
(1 r*)N:
Therefore, we can rewrite the expression from (b), imposing this condition:
TB1 TB2 TBN
(1 r*)W1 TB0 2 . . .
(1 r*) (1 r*) (1 r*)N
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-45
e. At year 0, what is the new PV(Q) in dollars? Hint: To ease computation, calcu-
late the value of the increment in PV(Q) due to the extra output in later years.
Answer: The present value of the increment in PV(Q) due to the extra output
equals 0 8.4/0.05 168, whereas the present value of entire stream of new
future output is:
Q 208.4
PV(Q) Q0 200 4,368
r* 0.05
f. At year 0, what is the new PV(I) in dollars? Therefore, what does the LRBC say
is the new PV(C) in dollars?
Answer: The present value of investment is:
PV(I) K 84
Using the LRBC, we can calculate the present value of consumption:
PV(C) PV(Q) PV(I) 4,368 84 4,284
g. Assume that Argentina is consumption smoothing. What is the percent change in
PV(C)? What is the new level of C in all years? Is Argentina better off?
Answer: The percent change in the present value of consumption (compared
with the case with no investment project) is 2% ( 84( 4,284 4,200)/4,200).
The new level of consumption in all years is:
C
PV(C) C
r*
C
4,284 C therefore C 204
0.05
Yes, Argentina is better off because consumption increases from 200 to 204 in
every period.
h. For the year the projects go ahead, year 0, explain Argentina’s balance of pay-
ments as follows: State the levels of CA, TB, NFIA, and FA.
Answer: In year 0, the values are as follows:
TB = Q C I 200 204 84 88
NFIA 0
CA 88
FA 88 (from the balance of payments, CA FA KA and KA 0 by as-
sumption in this question)
i. What happens in later years? State the levels of CA, TB, NFIA, and FA in year 1
and every later year.
Answer: In subsequent years, the values are as follows:
TB Q C I 208.4 204 0 4.4
NFIA 4.4 ( r* K 0.05 88)
CA 0 FA
4. Continuing from the previous question, we now consider Argentina’s external wealth
position.
a. What is Argentina’s external wealth W in year 0 and later? Suppose Argentina has
a one-year debt (i.e., not a perpetual loan) that must be rolled over every year.
After a few years, in year N, the world interest rate rises to 15%. Can Argentina
stick to its original plan? What are the interest payments due on the debt if
r* 15%? If I G 0, what must Argentina do to meet those payments?
Answer: Argentina borrows $88 in year 0, so its external wealth is $88 in year
0 and thereafter. The interest payments needed to service its debt rise from $4.4
to $13.2 ( 0.15 88). The only way that Argentina can make these payments
is through reducing consumption.
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-47
b. Suppose Argentina decides to unilaterally default on its debt. Why might Ar-
gentina do this? State the levels of CA, TB, NFIA, and FA in year N and all sub-
sequent years. What happens to the Argentine level of C in this case?
Answer: If Argentina defaults on this debt, NFIA 0 because external wealth
rises to 0.This means Argentina no longer needs to run a trade surplus, so its con-
sumption can increase by the $4.4 that was previously paid on its debt. TB
NFIA CA FA 0 and C $208.4.
c. When the default occurs, what is the change in Argentina’s external wealth W?
What happens to the rest of the world’s external wealth?
Answer: External wealth rises to 0. The rest of the world experiences an $88
decrease in wealth.
d. External wealth data for Argentina and Rest of the World are recorded in the ac-
count known as the international investment position. Is this change in wealth
recorded as a financial flow, a price effect, or an exchange rate effect?
Answer: In the net international investment position, this is recorded as a fi-
nancial flow.
5. Using production function and MPK diagrams, answer the following questions. For
simplicity, assume there are two countries: a poor country (with low living standards)
and a rich country (with high living standards).
a. Assuming that poor and rich countries have the same production function, illus-
trate how the poor country will converge with the rich country. Describe how
this mechanism works.
Answer: See the following figure.
q
A
qR
B
qP kP and qP rise
until qP ⫽ qR.
kP kR k
MPK
A
MPKR
kP kR k
S-48 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization
We know that living standards are measured by output per capita—this is directly
correlated with output per worker (denoted q on the diagram) and income per
worker. Therefore, according to the benchmark model (in which we assume the
same production functions in both countries), the reason the rich country is rich
is simple: it saves more and therefore has more capital per worker (denoted k on
the diagram) and therefore more output per worker. This is shown by the two
points A (rich country) and B (poor country). According to the benchmark
model, the gap in living standards should not persist. Because the marginal prod-
uct of capital is higher in the poor country, it will attract capital from abroad,
converging to the level of output per capita and output per worker observed in
the rich country. Over time, countries will converge to the same living standards.
b. In the data, countries with low living standards have capital-to-worker ratios that
are too high to be consistent with the model used in (a). Describe and illustrate
how we can modify the model used in (a) to be consistent with the data.
Answer: See the following figure.
q
A
qR
D
q P2
B C
qP
kP and qP rise,
but qP ⬍ qR.
kP kPdata kP2 kR k
MPK
B
MPKP
MPKPdata
C
A
MPKR
D
kP kPdata kP2 kR k
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-49
In the two graphs on the previous page, we observe a gap in living standards (qR
versus qP) that is inconsistent with the gap in capital to worker ratios (kR versus kP).
Specifically, the poor countries are saving a lot more than that implied by the
model. This is shown by point C in the figure. The way we can address this gap is
to assume the two countries have different production functions—specifically, they
have different productivity levels. From the diagram that follows, we see that this
implies poorer countries will not completely converge with their richer counter-
parts. With lower productivity levels, these countries will achieve a point at which
MPK r* at a lower level of capital per worker; therefore, they will have a lower
output per worker. We see the poor country converges to point D, at which the
marginal products are equal, but the poor country has a lower level of capital (and
output) per worker.
c. Given your assumptions from (b), what does this suggest about the ability of poor
countries to converge with rich countries? What do we expect to happen to the
gap between rich and poor countries over time? Explain.
Answer: With lower productivity levels, these countries will achieve a point
where MPK r* at a lower level of capital per worker; additionally, because of
a lower productivity, they will have a lower output per worker. The gap will per-
sist as long as the productivity levels differ.
Using the model from (b), explain and illustrate how convergence works in the
following cases.
d. The poor country has a marginal product of capital that is higher than that of the
rich country.
Answer: See figure for (b). Since the poor country's MPK is higher, capital flows
into the poor country, raising its living standards.
S-50 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization
e. The marginal products in each country are equal. Then, the poor country expe-
riences an increase in human capital through government funding of education.
Answer: See the following diagrams. This implies an increase in productivity
level. The gap between the living standards will be reduced because the poor
country is able to maintain a higher capital-to-worker ratio.
q
A
qR
E
qP2
D
qP
kP kP2 kR k
MPK
MPKP rises as
AP increases.
E A
r*
D
kP kP2 kR k
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-51
f. The marginal products in each country are equal. Then, the poor country expe-
riences political instability such that investors require a risk premium to invest in
the poor country.
Answer: See the following diagrams.This implies that investors require r* RP
MPKP to invest in the poor country.To pay the higher return to capital, the rate of
return on capital, i.e., the marginal product of capital, must increase so that MPKP
r* RP holds, which means that kP must decrease.
q
A
qR
D
qP
qP2 E
kP2 kP kR k
MPK
r* ⫹ RP
E
A
r*
D
kP2 kP kR k
S-52 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization
6. Assume that Brazil and the United States have different production functions q f(k)
where q is output per worker and k is capital per worker. Let q Ak1/3.You are told
that relative to the U.S. 1, Brazil has an output per worker of 0.32 and capital per
worker of 0.24. Can A be the same in Brazil as in the United States? If not, compute
the level of A for Brazil. What is Brazil’s MPK relative to the United States?
Answer: We can calculate the implied ratio of productivity levels ABrazil/AUS. Let P
denote Brazil (the poor country) and R denote the United States (the rich country).
Note the ratio of the marginal product of capital of each of the two countries is:
MPKP qP/qR 0.32
1.333
MPKR kP/kR 0.24
Note further that
MPKP qP/qR AP k1/3
P/AR AP/AR AP/AR AP/AR
1.33
MPKR kP/kR k1/3
R (kP/kR)2/3 (0.24)2/3
0.386
AP/AR 0.51 kP/kR
Therefore, Brazil’s productivity level is 51% of that in the United States.
7. Use production function and MPK diagrams to examine Turkey and the EU. Assume
that Turkey and the EU have different production functions q f(k) where q is out-
put per worker and k is capital per worker. Let q Ak1/3. Assume that the produc-
tivity level A in Turkey is lower than A in the EU.
a. Draw a production function diagram (with output per worker y as a function of
capital per worker k) and MPK diagram (MPK versus k) for the EU. (Hint: Be
sure to draw the two diagrams with the production function directly above the
MPK diagram so that the level of capital per worker k is consistent on your two
diagrams.)
Answer: See the following diagram.
b. For now, assume capital cannot flow freely in and out of Turkey. On the same di-
agrams, plot Turkish production function and MPK curves, assuming that the
productivity level A in Turkey is half the EU level and that Turkish MPK exceeds
EU MPK. Label the EU position in each chart EU and the label the Turkish po-
sition T1.
Answer: See the following diagram.
c. Assume capital can now flow freely between Turkey and the EU and the rest of
the world and that EU is already at the point where MPK r*. Label r* on the
vertical axis of the MPK diagram. Assume no risk premium. What will Turkey’s
capital per worker level k be? Label this outcome point T2 in each diagram. Will
Turkey converge to the EU level of q? Explain.
Answer: See the following diagram. Turkey’s capital per worker will rise once
capital flows freely between the two regions but it will still remain below the
capital per worker in the EU. This is because, initially, Turkey’s high MPK will at-
tract capital from abroad, increasing output per worker in Turkey. But a lower
productivity level in Turkey requires a lower capital per worker in Turkey for the
marginal productivity in the two regions to be equal. In equilibrium, Turkey's
capital per worker and output per worker will be lower than that in the EU.
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-53
q
A
qEU
T2
qT2
T1
qT
kT and qT rise,
but qT ⬍ qEU.
kT kT2 kEU k
MPK
MPKT
T1
A
r* ⫽ MPKR
T2
kT kT2 kEU k
8. This question continues from the previous problem, focusing on how risk premiums
explain the gaps in living standards across countries.
a. Investors worry about the rule of law in Turkey and also about the potential for
hyperinflation and other bad macroeconomic policies. Because of these worries,
the initial gap between MPK in Turkey and r* is a risk premium RP. Label RP
on the vertical axis of the MPK diagram. Now where does Turkey end up in
terms of k and q?
Answer: Turkey will be forced to remain at a lower capital per worker (versus
the EU) because the risk premium means MPKT RP r*. Turkey’s k and q
will be lower than those in the EU.
S-54 Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization
q
A
qEU
T2
qT
q T3
T3
kT and qT fall with a
rise in risk premium.
k T3 kT kEU k
MPK
r* ⫹ RP
T3
A
r*
T2
kT3 kT kEU k
The present value of government spending is equal to 11, as this is a one-time increase
in government spending. Therefore, the present value of consumption is:
50
PV(C) PV(Q) PV(G) 50 11 539
0.10
To determine the level of consumption each period, we know that the country wants
to maintain a given level of consumption:
C
PV(C) C
r*
C
539 C therefore C 49
0.10
To consume 49 units, along with the war expenditure of 11 units, the country needs
to borrow 10 units.
If the government needs to borrow again, then we can use the same approach to find
consumption each period. Note that for every 10 units borrowed, consumption is re-
duced by one unit, as NFIA 0.10 10 in subsequent periods. Therefore, in pe-
riod 0, C 49. Thereafter, when the government needs another 11 units, beginning
in period 1, C 48 (as NFIA increases by one additional unit).
12. Consider a world of two countries, Highland (H) and Lowland (L). Each country has
an average output of 9 and desires to smooth consumption. All income takes the form
of capital income and is fully consumed each period.
a. Initially, there are two states of the world: Pestilence (P) and Flood (F). Each hap-
pens with 50% probability. Pestilence affects Highland and lowers the output there
to 8, leaving Lowland unaffected with an output of 10. Flood affects Lowland and
lowers the output there to 8, leaving Highland unaffected with an output of 10.
Devise a table with two rows corresponding to each state (rows marked P and F).
In three columns, show income to three portfolios: the portfolio of 100% H cap-
ital, the portfolio of 100% L capital, and the portfolio of 50% H 50% L capital.
Answer: See the following table.
P 10 8 9
F 8 10 9
b. Two more states of world appear: Armageddon (A) and Utopia (U). Each happens
with 50% probability but is uncorrelated with the P-F state. Armageddon affects
both countries equally and lowers income in each country by a further 4 units,
whatever the P-F state. Utopia leaves each country unaffected. Devise a table with
four rows corresponding to each state (rows marked PA, PU, FA, FU). In three
columns, show income to three portfolios: the portfolio of 100% H capital, the
portfolio of 100% L capital, and the portfolio of 50% H 50% L capital.
Answer: See the following table.
PU 10 8 9
FU 8 10 9
PA 6 4 5
PA 4 6 5
Solutions ■ Chapter 6(17) Balance of Payments I: The Gains from Financial Globalization S-57
Compare your answers to (a) and (b) and consider the optimal portfolio choices.
Does diversification eliminate consumption risk in each case? Explain.
Answer: In (a), Lowland and Highland are each able to eliminate exposure to
risk through investing equally in capital at home and abroad. This is because all
shocks in this part are idiosyncratic and are negatively correlated. In (b), the
countries are able to reduce some of the volatility in capital income through di-
versification, but not completely. This is because both countries are subject to
common shocks (Armageddon) that cannot be diversified away. This state uni-
formly reduces capital income in both countries.
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