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The author is grateful to Michael Gavin, Elhanan Helpman, Vincent Reinhart, Carlos Végh, and Peter Wickham for helpful comments and suggestions on an earlier draft.
To economize on space, the expressions for countries B and C are omitted. In the case of country C, the maximization problem reduces to a static Langrangean.
The intuition behind consumption dynamics of households in country C, DcC = -αBCDrA, is straightforward. Unless country C residents opt to default on their debt servicing, consumption must be declining when the interest rate is rising and vice-versa.
Output of good 1, YA, has no intrinsic dynamics as it only depends on relative prices, which adjust instantaneously.
As (20a) illustrates, the government spending “multiplier” is less than one.
Recall the debt is denominated in terms of the good whose relative price has risen.
Although we can only make statements about output levels, as this is not a growth model.
For a model that links the terms of trade to debt, as well as for a discussion of key stylized facts in this area, see Aizenman and Borensztein (1988).
In the case where the real exchange rate appreciates, the output expansion in country B is smaller than when the real exchange rate depreciates.
Latest year for which this statistic is available.
It is evident that the price of the bond, vt, cancels out of the budget constraint, but for the time being, we will retain it to facilitate illustrating what happens when intertemporal preferences change.