TERM 1: External adjustment Flashcards
What is the ultimate goal of households?
CONSUMPTION SMOOTHING
Investment schedule depends on:
negatively on r1
positively on A2
Savings schedule depends on:
positively on r1
positively on Q1
negatively on Q2
How does rise in Q2 affect S1?
expected rise in Q2 = also increase C1 to smooth consumption. Do this by borrowing therefore savings fall.
CA is the difference between
Savings and investment (horizontal distance between schedules)
In a closed economy:
S=I always, CA = 0 and IR clears domestic asset market.
In a small open economy:
Take world IR as given: r1=r*
S≠I
CA≠0
Impact of rise in world IR on CA (small open economy)
Rise in r* causes C1 fall; S1 rise (SE>IE)
Rise in r* causes I1 fall
Movement along the schedules - no shift
CA improves
Impact of rise in Q1 on CA (small open economy)
No change in investment as doesn’t depend on current output.
Higher Q1 = C1 rises, but by less than rise in Q1 = S1 rises
Savings schedule shifts right
At world IR, CA improves
Impact of future productivity shock on CA (small open economy)
A2 rises = investment schedule shifts right
A2 rises causes Q2 rise = C1 rises = S1 shifts left
At world IR, CA deteriorates
Impact of expected future TT depreciation on CA (small open economy)
TT depreciation = like a negative endowment shock
Decrease C1 and increase S1 as precautionary saving
Savings schedule shifts right
No change in I
CA improves
IR risk premium for different countries
r1 = r* + p for debtors r1 = r* for creditors
Why must debtors offer at IR risk premium?
Higher risk of default
In order to encourage international investors to still buy their government bonds, must offer higher return
Therefore higher domestic IR
Effect of constant risk premium on CA
Upwards shift of IR horizontal line
CA improves
Effect of increasing risk premium on CA
r* when CA>0
when CA<0, r+p(-VE)
So as CA becomes more negative, premium greater = upwards sloping line
If domestic CA shifts left, CA deteriorates but due to higher IR, not as bad as if r1=r
Equilibrium in large open economy
r1≠r*
CA US + CA ROW = 0
Effect on IR and CA in closed economy of CA shifting left
S=I always
If CA shifts left, excess I = domestic IR increases until asset market clears again
Large increase in domestic IR, no change in CA=0
Effect on IR and CA in small open economy of CA shifting left
Large change in CA
No change in IR as = r* world IR which is given
Effect on IR and CA in large open economy of CA shifting left
US debt must = ROW saving
If US want to borrow more, ROW needs to save more = incentivise: US influence world IR so it rises.
CA US’ + CA ROW = 0 at higher world IR
Small change in IR; small change in CA - deterioration not as bad as for small open economy.
US CA huge deteriorate between
1996 to 2004
2 alternative explanations for US CA deterioration
- Made in USA hypothesis
2. Global savings glut hypothesis
Explain made in USA hypothesis
US CA deterioration due to domestic shock causing US CA schedule to shift left.
Due to financial innovation –> lower savings rate & over-investment in housing.
Explain global savings glut hypothesis
US CA deterioration due to external factors causing ROW CA schedule to shift left i.e. improve. Over past decade huge increase in global supply of savings.
3 reasons for global savings glut
- Emerging markets accumulating foreign reserves to prepare to future crises & avoid 1990s experience.
- Export-led growth due to ER manipulation (undervalued currency)
- Foreign developed countries increased saving due to ageing population e.g. Japan
How do IR change under Made in USA hypothesis
US want to borrow more = need to raise world IR so ROW saves more = higher IR
How do IR change under global savings glut hypothesis
ROW increased saving = must incentivise US to borrow more = lower world IR
Which hypothesis was correct in the data?
Data showed CA reversal which could be either.
But World IR fell = consistent with global savings glut hypothesis.
Fisher’s equation
(1+rt) = (1+it)/Et Pit+1
Real IR = nominal IR - expected inflation
Improved of US CA after 2006 explained by:
NOT due to subsiding of global savings glut, as in that case world IR would’ve risen, but they continued to fall.
