Reading Capital Flows Consumption Smoothing
Consumption Smoothing
Basic Framework
Consider a two-period small open economy (SOE) model,
with exogenous world interest rate r
Let the discount factor be = 1
1+ .
Household receives endowments/incomes Y1 & Y2 in periods
1 & 2.
Its (lifetime utility) maximisation problem is:
maxU = u(C1) + u(C2) w:r :t: C1 & C2 (1)
subject to following present value budget constraint:
C1 +
C2
1 + r
= Y1 +
Y2
1 + r
(2)
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