Current Account - determination & schedule Flashcards
What components make up the current account?
Current account = TB + IB + NUT
What does the current account show?
= net ∆ in international debt/credit per year
What is the trade balance, and give an equation for it.
Trade balance is a countries net trade in goods + services TB = X-IM
What is the income balance, and give an equation for it.
Income Balance measures the flow of income to/from the rest of the world IB = net investment income (income from capital)+ net international payments to employees (Income from labour)
What is the net unilateral transfers, and give an equation for it.
Net unilateral transfers is the difference between gifts received and given to/from the rest of the world NUT = private remittance + government transfers
What does CAUS+CAROW=0 imply?
That the sum of CA must = 0
Therefore, countries may diverge, creating global imblances where some countries are debtors and others are creditors.
What is the equation linking CA, savings and investment?
Dervive
=net foreign assets in period 1, r=interest rate
As , and adding to each side:
As the national income = GDP + net investment income, , and
As
Define Net International Investment Position, NIIP, in words + an equation
NIIP = Difference between a country’s foreign assets and its foreign liability
NIIP = A – L = domestic owned foreign assets – foreign owned domestic assets
What does a -ve NIIP mean?
The country is a net debtor
What is a change in NIIP equal to?
What are valuation changes?
Valuation changes = changes in the market value of the country’s foreign asset and liability positions due to currency appreciations, deprecations, changes in stock price, etc.
How do you calculate the hypothetical NIIP and what does it show?
Take a base year CA, and sum the CAs from that year on to create a hypothetical NIIP
Shows how valuation changes have benefited/hindered a countries debt position
What is the negtive-NIIP-positive-NII paradox?
Some countries have -ve NIIP, but +ve net investment income
Give the 2 explinations of the negative-NIIP-positive-NII paradox
Dark matter + Return differentials
Explain what dark matter is, and how do you calculate it?
Dark matter - accounting failures lead NIIP to be –ve, but it is actuall +ve
TNIIP = the ‘true’ NIIP NIIP = observed NIIP NII = net intvestment income
- Dark matter = TNNIP-NIIP
Explain what return differentials are, and how do you calculate it?
Return differentials - the relative interest rates on the liabilities and assets differ explaining the NIIP paradox
Assets are often high-rent, and gross liabilities are often composed of safer low-return assets. This return differential can lead to the NIIP-NII paradox.
Return differential =
average real rate of terturn on US T-bills
Can an economy run a perpetual TB deficit? Show your result with algebra
(for a 2 peroid endowment economy, assuming unilateral transfer=0 and no net transfer to employees =0)
Yes if
NIIP at the end of period 1:
NIIP at the end of period 2:
Transitivity condition = No-ponzy-game + optimality condition:
NIIP (including interest) = present discounted value of the future trade deficits.
This implies:
If net debtor,, then must run a TB surplus at some point.
If net creditor,, then can afford running TB deficits in both periods.
What is the ponzy game condition? (in words and alegrbrically or both 2 peroid and infinite horizon economies)
2 peroid
As the economy ends at the end of period 2, the country can’t hold assets or debts as no one will be able to find a creditor ( ) and has no benefit to lend .
Transitivity condition = No-ponzy-game + optimality condition:
Infinite horizon:
No-Ponzi-game constraint becomes:
àshows that you can’t increase debt at a rate that you can keep up with the repayments - Present day value of asset at final period has to be +ve
Optimality/transversality condition:
Can an economy run a perpetual CA deficit? Show your result with algebra
(for a 2 peroid endowment economy, assuming unilateral transfer=0 and no net transfer to employees =0)
yes if
This implies:
If net debtor, , then must run a CA surplus at some point.
If net creditor, , then can afford running CA deficits in both periods.
Can an economy run a perpetual TB deficit? Show your result with algebra
(for an infite horizon economy, assuming unilateral transfer=0 and no net transfer to employees =0)
Shift this expression 1 period forward:
Combine formula to eliminate
Repeat this T times to get:
current wealth/debt = current value of sum of TB
This implies:
If net debtor, , then must run a TB surplus at some point.
If net creditor, , then can afford running TB deficits in all periods.
Can an economy run a perpetual CA deficit? Show your result with algebra
(for an infite horizon economy, assuming unilateral transfer=0 and no net transfer to employees =0)
yes if** **or** **but GDP growth rate ≥
Assumming the country is initially a net debtor & recall motion of debt:
The country generates TB surplus to pay a fraction, , of its interest obligations: where
recall current account:
- current account will always be –ve
What abut the transversality condition?
& divide each side by
As t becomes larger this converges to 0 as
this satisfies the transversality condition
Then TB becomes:
a country can operate perpetual -ve current account even when. However, their debt increases year on year at a rate of as do the interest paymentsthe TB required to keep up with interest payments needs to grow at an unboundedly rate of àin order for a country to be generate this path of TB surpluses, its GDP must grow at a rate ≥
What is the intertemporal budget constraint, in maths and graphically.
- 2 period small open economy
- The economy received endowments of and in periods 1 and 2
- Initial wealth is inherited from the past. Here are bonds that paid the interest rate.
- In period 1, households choose consumption and bond holdings , which pay interest rate
Present day value of consumption = present day value of endowment + initial wealth
What is the slope of the intertemporal budget constraint?
Slope = -
= price ratio of consumption periods / cost of borrowing or benefit of lending
Given and the lifetime utility function: , find optimal consumptions
sub in
- increasing in Q1,Q2&
- decreasing in r1.
What are the effects of an endowment shock on consumption and CA in a small open 2 peroid economy?
Change in, anddepends if shock if temporary or permanent
Effect on consumption:
Tempt shock: >0 , =0 -
Permanent shock: = >0 -
As r is so small
If shock is temporary – income smooth
If shock is permeant – consume all
Effect on Current Account:
Remember: .
Assume free international capital mobility which implies: r1=r*, due to arbitrage (if r1>r* high demand leading to increase in price, a fall in r1 until r1=r*)
Temp shock: >0 , =0 -
Permanent shock: = >0 -
(remember r is very small)
Temporary shock - consumption smooth by finance shock by, without changing consumption too much
Permanent shock - Adjust by changing consumption without much
Define terms of trade
Relative price of export goods in terms of import goods:
What is the intertemporal budget constraint of a small open 2 peroid economy with terms of trade?
Present day value of consumption = present day value of endowment of exportable goods in terms of importable goods + initial wealth
How does a change in the terms of trade effect consumption and CA in a small open 2 peroid economy?
Terms-of-trade shocks affect the C, TB and CA the exact same way endowment shocks do. Temporary changes will have little effect on consumption, and large effect on TB and CA a lot & permanent shocks will have large effect on consumption and little effect on TB and CA.
How can we see if agents think a shock is temporary or perminent?
By looking at what the CA does - if CA +ve, perceived temporary shock.
What does a change in interest rates do to a small open 2 peroid economy intertemporal budget constraint?
roates budget constaint around the endowment point
How does a change in interest rates effect consumption, TB and CA?
- C falls as increases
- TB increases as increase
- CA increases as increase
What is the subsitution effect?
The substitution effect:
- Increase in r makes saving more attractive
What is the welath effect?
Wealth affect:
- increase in r makes creditors richer and debtors poorer
Which is stronger - the sub or welath effect?
substitution effect>wealth effect
What are capital controls?
Where the gov. try to decrease CA deficits to boost future consumption - prohibit international borrowing, taxes on borrowing or interest on external debt
(note: only binding if country is a debtor)
How do capital controls work? (graphically and words)
As Gov. prohibits international borrowing, gov. increases until A is optimal bundel, or if they prohibit all borrowing,will increase until A is optimal.
- This does boost future consumption but reduces welfare!
How do you calculate the optimal r for capital controls?
Divide by
, recall
lower the current output relative to future output, the more people want to borrow against future output – reducing interest rate
How does output and the marginal production of capital change with change in A (the efficiency parameter)? (Words + graphically)
Output and MPK increase is A increases and vis versa.
For a productin economy, given: , , (borrow in peroid 0 to finance investment).
What is the profit function, and optimal level of investment? (mathmatically + grpahically)
Firms profit:
Optimal investment:
What is the investment scedule, and what does it look like grpahically?
Investment schedule = how investmentwith
- Investment is decreasing in r, and shifts with A
Derive the intertemporal budget constraint for a production economy
Where: , = period 0 endowment of bonds (only endowment), and firms borrow in period 1 to finance investment ( ), at interest rate r.
Households own firms, and = period 0 endowment of bonds
Budget constraint in peroid-1:
Budget constraint in peroid-2:
Transversality and optimum condition:
In an small open economy: , and = NIIP
What is the optimality condition for a production economy?
– MRS=MC àgradient = gradient
What is the CA & TB equations in a production economy?
Trade balance in period 1:
Current account in period 1:
What is the equation for national savings in a production economy?
What effect does an increase in interest rates have on national savings, and how is interest rates and savings related?
The substitution effect: - saving is more attractive
Income affect:
- decreases future profits, and also makes borrowers richer and savers poorer
Substitution effect>wealth effectsavings is a +ve function of interest rate
What is a collateral constraint?
Collateral Constraint:
A constraint on how much an borrow, , and the desired (non-constraint) level of investment, . Actual investment is:
What is the saving schedule, and what affects it?
- upwards sloping as substitution effect>income effect
- incorporates consumption smoothing
Savings increasing in r
Shifts right with increase in
Shifts left with increase in
What is the current account schedule and how is it derived?
Increasing in r
Shifts right when gap between S and I increases, and left when it decreasing
What is the CA in a closed economy?
In a closed economy – no CA as no trade with the rest of the world, so r = equilibrium r that clears the domestic investment market
How does interest rate effect the current acount scheule?
Cost of I increases move up I(r), savings increase as SE>IE move up S(r) - gap decreases + CA unmoved, but point on it moves rightwards - CA improves
How does a temporary output increase in Q1 affect the CA schedule?
A temporary output increase in Q1: household want to income smooth so savings increase S(r) shifts right gap decreases and CA improves at all levels fr r - CA(r) shifts to the right
How does an increase in future productivy affect the CA schedule?
higher productivity leads to higher returns at all levels of r I(r) shifts to the right. Increased productivity, leads to increased expected Q2, households want to income smooth so reduce savings at all levels of r, S(r) shifts to the left larger gap anda depreciation of the CA at all levels of r - CA shift to the left
How does a deprication in the expected future terms of trade affect the CA schedule?
same as an expected fall in Q2: households want to income smooth and increase savings at all levels of r S(r) shift to the right smaller gap and an improvement of the CA at all levels of r - CA shifts to the right
What is a countries risk preium? (show it mathamtically and graphically)
= country risk premium
How does the level of debt affect the risk premium?
As more debt accumulates – risk premium increasesp(-CA)
What is a equilvilent to the arbitrage condition for large open economies?
Instead r is such that:
How does a shift in the CA schedule effect:
1) Closed economies?
2) Large open economies?
3) Small open economies?
1) Closed economy – CA=0 therefore r changes a lot
2) Large open economy – CA change a bit and r changes a bit
3) Small economy – big change in CA and no change in r
In 1996 the US CA fell - name the 2 hypothesis, and we can emprically tell which one was correct.
Made in the US (r increases), and the global glut hypothesis (r decreases).
r decreased so glub hypothesis was correct
Explain the made in the US hypothesis (why US CA fell in 1996)
CA deterioration due to development inside the US (independent of ROW)– increase A in US US wanted to borrow to invest CAUSshifts up
Explain the global glut hypothesis (as to why the US CA fell in 1996)
CA deterioration due to external factors - increase in global supply of savings CAROWshifts down - - due to:
1) people preparing for future crisis to avoid the experience of the 1990s recession
2) export-led growth (brought about via exchange rate manipulation – undervalued currency)
3) foreign developed countries are saving more in prep for an aging pop
How do we calculate rest interest rate?
(fishers equation)
Constructing real interest rate – fisher equation:
Where Expected gross inflation be t and t+1
And i is the interest rate of of a 1 year treasury bond
