Exercise 12.4
Financial Amplification
Problem
Consider the economy of Section 12.4, which features two equilibria, one in which the collateral constraint never binds (point \(A\) in Figure 12.4), and one in which the collateral constraint binds in period 0 (point \(B\) in the same figure). Suppose that the endowment of tradables, \(y^T_t\), increases permanently in period 0. Suppose that the increase in \(y^T_t\) is sufficiently small to ensure that the constrained equilibrium continues to exist. Show that in the unconstrained equilibrium, traded consumption in period 0, \(c^T_0\), increases one-for-one with \(y^T_0\), whereas in the constrained equilibrium, \(c^T_0\) increases by more than one-for-one with \(y^T_0\). Provide intuition. Comment on the responses of the trade balance, the current account, and the real exchange rate in the constrained and unconstrained equilibria.
Answer
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