Assume a two-period model where national income is 100 in the current period, and 120 in the future period. The world real interest rate is assumed to be 10% per period. The representative consumer always wishes to set current consumption plus government spending equal to future consumption plus government spending (C + G = C’+ G’), which implies perfect complements preferences.
(a) Determine consumption plus government spending in the current and future periods, and the current account surplus. Draw a diagram to illustrate your results.
(b) Now, suppose that the world real interest rate increases to 20% per period. Again, determine consumption plus government spending in the current and future periods and the current account surplus, and show these in your diagram.
(c) Explain the difference in your results in parts (a) and (b).
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