Small open economy Flashcards
Assumptions of SOE model including contraints
-Endowment economy in two periods, current and future consumption.
-SOE therefore r = r*, interest/price taker. Domestic rate = global rate.
-international borrowing and lending is now available with no restrictions (may change)
-A countries CA balance over a period is the change in value of its net claims on the ROW (change in net foreign assets, NFA). CA is in surplus (domesic economy is lending abroad) if this is positive vise versa.
-Ricardian equivalence still holds within this model, the timing of taxation doesn’t matter as they are in lump sum format.
-Gov and HH’s save, Sg = T - G, Sp = Y - C - T, National saving given by Sg + Sp = Y - C - G = CA.
-National budget constraint can be simplified to CA = -CA
CA and What causes the CA to rise + CA formula for current and future
-Current accounts will rise with the following:
-Increase current Y. Increase in Y will increase current C.
-Decrease in future income, Y1 (raises current income)
-A decrease in G (CA = Y - C - G)
-Current CA = S = Y - G - C
-Future Ca = Y’. - G’ - ‘C’ +Sr (CAr)
-Graphically changes in world r* increases steepen BC around E point
Credit imperfections in SOE assumptions
–The limited commitment constraint refers to V >= B1. Cost of defaulting, what lenders receive if domestic economy defaults must be greater of equal to the value of the debt in the future period.
-Domestic econonomy H can defaultCost involved with defaulting = v
-By introducing v new constraint becomes:
C+G <= Y - B + v/1+r
-Dom econ can borrow B1/1+r and repay B1 in next period.
-B and B’ and borrowed amounts in both periods.
Why increases in furture expected z has no impact on SOE
-With news about expected increase in the TFP, consumption rises, investment also rises, firms know future workers/capital more produce higher incentive to invest.
-However Ys doesn’t shift as current production technologies have yet to change, not a temporary change it is a future change. This implies there is no effect on current output therefore NX must fall. CA deteriorates.
Eg) H defaults, Would it ever be optimal for a domestic country to defaul draw graph + default condition
-Assume H defaulkts on b, therefore b = 0.
-Assume B’ = 0 H cannot access debt markets due to defaulting in first period.
-H incures a pentaly of v
-Budget constraint = C+G <= Y - B + v/1+r
-Assume H can consume thorugh its outputs therefore may be optimal to deafult. Whether optimal depends on the position of Y - B +v/1+r compared to Y
-Exaplain how changes in B v and r improve optimality of defualt or not.
-Can show optimal/not optimal on grsph shows point of no default and default.
-Optimal to default if B > v / 1+r (on graph default at Y on x axis)
SOE with exogenous output assumpyions and movements of YD and relation to NX
-domestic economy output to be endogenous, not determined by endowment structure.
-In the SOE model the real interest rate is exogenous, determined by global.
-This means that equilibrium is set whether output supply interests with r*
-Draw YS and Yd normally. Change in world interest rate exogenous (draw horizonal line), shift YD to make equilbirum. IF shifts left NX < 0 if right NX > 0. Also account for changes in YS that moght occur before shifting Yd.
