Chap 6 Flashcards
What is Consumption smoothing ?
- The steady consumption when income fluctuate
what is Efficient investment ?
- The borrowing to build a productive investment
What is diversification of risk?
- The trade of stocks between countries
What is LRBC ?
- Long- run budget constraint
- I tell us the ability to borrow (in times of need ) and the ability lend (in times of prosperity ) in the long run
- It uses change in an economy’ external wealth to determine the limits of borrowing in the long run
what is a “debt that is not served” ?
- When the interest payment or the principal is pay
what is a debt that is serviced ?
- When ONLY the interest is pay
What mayor assumption is in the LRBC ?
- Small open economy
- Real economy
- World interest rate
- Start period payment
- No unilateral transfer (NUT = 0) and no capital transfer (KA = 0)
- current account only affected by TB and NIF
Explain the assumption of small open economy in LRBC?
- The country is. price taker
- It cannot influence prices or real interest rate
Explain the assumption of real economy in LRBC ?
- Prices are perfectly flexible
- The analysis in real variables and we ignore monetary aspect of the economye
Explain the assumption of World real interest rate in LRBC ?
- the assumption is that it is constant
- a country can borrow unlimited amount at this interest
Explain the assumption of start period payment in LRBC ?
- The assumption that payment are done at the start of the period (fiscal year)
Explain the assumption of NUT and KA in LRBC ?
- The assumption that there is no capital transfer or capital gains on external wealth
Formula for Change in Wealth (per period) :
Wn = Wn - Wn-1 = TBn + r* ( Wn-1)
Wn - Wn-1 : change in external wealth
TBn : Trade balance (this period)
r* ( Wn-1) : interest paid/ received ( on the last period’ s external wealth)
r*: interest rate
Formula for Future Wealth Levels :
Wn = TBn + (1 + r*) Wn-1
Wn : External wealth at the end of this period
TBn : Trade balance (this period)
(1 +r*) Wn-1 : Last period’s external wealth ( plus interest paid/ received)
r*: interest rate
Formula for Two-period budget constraint : (inconpleto)
- (1 + r)^2 . W-1 = (1 + r) TB0 + TB1
r*: interest rate
Formula for PV form :
- ( 1 + r) W-1 = TB0 + (TB1 / 1+r )
- ( 1 + r*) W-1 : Minus the present value of wealth (from last period)
TB0 + (TB1 / 1+r* ) : Present value of all present and future trade balances
r*: interest rate
Formula for PV in the long run :
- ( 1 + r) W-1 = TB0 + (TB1 / 1+r ) + (TB1 / 1+r* )^2 + …
Formula for PV perpetual loans :
( X / 1+r* ) + ( X / 1+r* )^2 + ( X / 1+r* )^3 + … = X / r*
Formula for LRBC ( TB = GPD - GNE):
PV GNE = ( GNE / 1+r* ) + ( GNE / 1+r* )^2 + ( GNE / 1+r* )^3 + …
Also the theory indicated that it is equal to the GDP
( 1 + r)W-1 + ( GDP / 1+r ) + ( GDP / 1+r* )^2 + ( GDP / 1+r* )^3 + …
Present value of wealth + PV GDP (present and future)
Complete formula for Change in Wealth:
Wn = Wn - Wn-1 = TBn + r* ( Wn-1) + (r*-r0 ) L + KG
Wn - Wn-1 : change in external wealth
CONVENTIONAL EFFECTS
TBn : Trade balance (this period)
r* ( Wn-1) : interest paid/ received ( on the last period’ s external wealth)
r*: interest rate
ADDITIONAL EFFECTS (r*-r0 ) L : Income due differential in interest rate
KG : capitals gains from abroad
Can countries used their external wealth as a buffer ? and why ?
- Yes , the purpose is to smooth consumption in the face of fluctuations (in output or investment )
- However, each country have limits : debts
What happens with smooth consumption levels when a shock is permanent ?
- Consumers smooth out temporary shocks
- Adjustment is far smaller of the shock (immediately and fully complete)
What it means “save for rainy days “ in financial openness context ?
- Using financial institutions to smooth consumption fluctuations
- In open economy, a desire consumptions path (without effect of fluctuations) can be achieved by having trade deficits .
- In close economy Q = C , output fluctuation affects consumption
What is precautionary saving for governments ?
- the acquisitions of a buffer of external assets “rainy day funds”
Forms of precautionary saving :
- Foreign reserves (central bank)
2. Sovereign wealth funds (state assets management companies )
Formula for GDP in present time and no government :
PV (Q) = PV GNE
PV (Q) = PV C + PV I
Q: output
C : consumption
I: investment
Exercise: (financial market and transfer to help offset a negative shock)
- A college student needs to repeat a class, leading to a one time higher tuition
- The student can borrow to finance the increase in tuition and repay the loan over time
because education is viewed as CAPITAL INVESTMENT
(increasing productivity and potential earning )
Exercise: (financial market and transfer to help offset a negative shock)
- A small business owner in LA faces reduction in sales and damage to the property due to a earthquake
- To rebuild lost capital, the owner can borrow
- As her sales recover and production increase , he will be able to repay over time
Exercise: (financial market and transfer to help offset a negative shock)
- Bangladesh experiences widespread physical damage and job loss from the monsoon
- the gov can borrow to rebuild capital after the hurricane
- production increase , he will be able to repay over time
