(solution) Consider a world economy with international capital flows, but suppose that because of sovereign…

(solution) Consider a world economy with international capital flows, but suppose that because of sovereign…

Consider a world economy with international capital flows, but suppose that because of sovereign default risk a country cannot borrow more than a fraction φ > 0 of its capital stock. Consequently, in Section 19.1, we have the restriction that a˙j (t) ≤ φkj (t). (a) Characterize the steady-state equilibrium of the world economy and show that the steady state is not affected by this constraint. Explain the intuition for this result carefully. (b) Characterize the transitional dynamics of the world economy under this constraint. Show that Corollary 19.1 no longer holds.