Exercise 10.5
Interest-Rate Shocks, Capital Controls, And Unemployment
Problem
Consider the analytical example of Section 10.4. In that example, in response to a temporary decline in the interest rate from \(r\) to \(\underline{r}\), the Ramsey optimal capital control policy induces a constant path for tradable consumption and ensures full employment at all times. The Ramsey planner achieves this allocation by imposing capital controls in period 0 to make the effective interest rate perceived by domestic households, \((1+\underline{r})/(1-\tau^d_0)\), insensitive to the change in the world interest rate. These results hinge on the assumption \(\alpha>r\). Redo the analysis of Section 10.4 assuming that \(\alpha<r\). Provide intuition.
Answer
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