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Carmen M. Reinhart is an Economist in the Research Department. She holds a Ph.D. from Columbia University.
The author is grateful to Alberto Giovannini, Michael Gavin, Elhanan Help-man, Vincent Reinhart, Carlos Végh, and Peter Wickham for helpful comments and suggestions.
To economize on space, the expressions for country B and country C are omitted. In the case of country C, the maximization problem reduces to a static Langrangian.
The significance of assuming that the government only purchases the domestically produced good will become more evident in the next section when a change in fiscal policy is considered.
The intuition behind consumption dynamics of households in country C, DcC — α BC DrA, 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 I, YA, has no intrinsic dynamics since it depends only on relative prices, which adjust instantaneously.
Recall the debt is denominated in terms of the good whose relative price has risen,
In this case, the market-clearing condition for good 2 (equation (13)), would be revised to include an additional term
Although one can only make statements about output levels, since 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.
It is evident that the price of the bond, vt, cancels out of the budget constraint, but it will be retained for the time being to facilitate illustrating what happens when intertemporal preferences change.