Question: Assume that a country produces an output Q of 50 every year. The world interest rate is 10%. Consumption C is 50 every year, and I = G = 0. There is an unexpected war in year 0, which costs 11 units and is predicted to last one year. If the country desires to smooth consumption, how much should it borrow in period 0? What will the new level of consumption be from then on?
- The country wakes up in year 1 and discovers that the war is still going on and will eat up another 11 units of expenditure in year 1. If the country still desires to smooth consumption looking forward from year 1, how much should it borrow in period 1? What will the new level of consumption be from then on?