Assume that a country produces an output Q of 50 every year. The world interest rate is 10%. Consumption C is 50 every year, and I = G = 0.

Assume that a country produces an output Q of 50 every year. Theworld interest rate is 10%. Consumption C is 50 every year, and I = G = 0. There is an unexpectedwar in year 0, so output falls to 39 and is then expected to return to 50 in every future year. If the country desires to smooth consumption, how much should it borrow in period 0? Whatwill the the level of consumption and the trade balance be from then on? If the shock were permanent how would this change? Why would a country desire to smooth consumption?

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