1. If a country's consumption is based on the permanent income theory, suppose that today's income (period 1) is $100 and is expected to rise to $200 and $300 in period 2 and 3, respectively. Assume that the planning horizon is of course three periods, and that the interest rate and the rate of time preference are both zero. Also assume that investment and government expenditure are nil.(a) What would be the optimal consumption?(b) Now suppose that the expected income for period 3 goes up to $600. What would happen with optimal consumption? (c) What is the current account balance in period 1 under both scenarios? What equation seen in class would explain this current account behavior?(d) Imagine now a closed economy. Given this income profile over time, what would be the consumption in each period under the initial scenario?
2. Consider a large economy, say the United States, that has influence on the determination of the international interest rate. Explain what should happen to this international interest rate if the following changes take place in the U.S.: (a) the old age dependency ratio increases; (b) The GDP growth rate becomes much more volatile; (c) The federal deficit increases; (d) A massive credit promotion policy is implemented allowing a large number of households and firms to obtain loans.
3. In the cases presented in question (2), if the U.S. current account was initially balanced, how would this current account balance be affected by each of the above changes?
4. Why is intertemporal solvency a concept difficult to operationalize and what is the advantage and the limitation of the standard external debt sustainability analysis?
5. What are the foundations and the use of the studies on country risk premium and how good are the empirical models in explaining this variable?
6. Why do we say that credit ratings are good predictors of interest rate spreads (risk premium) but they do not seem to internalize all the relevant information for investors?