If, in an open economy with a real world interest rate of 5%, an output shock (decline) of 21% occurs followed by a recovery the next year:
A) no consumption smoothing is possible.
B) the nation can borrow 20% of GDP in the first year and repay 1% of GDP each year in perpetuity resulting in consumption smoothing.
C) then no borrowing is possible because of the possibility of exceeding the long-run budget constraint.
D) the economy would have to forswear all international trade and financial flows.

Question

Quizplus · Accepted Answer

With a 21% decline in output, it is not possible to fully smooth consumption. However, the nation can borrow up to 20% of GDP in the first year and pay back 1% of GDP each year from then on. This strategy ensures that consumption is not overly disrupted in the short term, while still adhering to the long-run budget constraint. Option A is incorrect because some consumption smoothing is possible. Option C is incorrect because the proposed borrowing plan does not exceed the long-run budget constraint. Option D is incorrect because there is no indication that the shock would require the economy to give up international trade and financial flows.

If, in an Open Economy with a Real World Interest