TERM 1: External adjustment

Question 1

What is the ultimate goal of households?

Answer 1

CONSUMPTION SMOOTHING

Question 2

Investment schedule depends on:

Answer 2

negatively on r1

positively on A2

Question 3

Savings schedule depends on:

Answer 3

positively on r1
positively on Q1
negatively on Q2

Question 4

How does rise in Q2 affect S1?

Answer 4

expected rise in Q2 = also increase C1 to smooth consumption. Do this by borrowing therefore savings fall.

Question 5

CA is the difference between

Answer 5

Savings and investment (horizontal distance between schedules)

Question 6

In a closed economy:

Answer 6

S=I always, CA = 0 and IR clears domestic asset market.

Question 7

In a small open economy:

Answer 7

Take world IR as given: r1=r*
S≠I
CA≠0

Question 8

Impact of rise in world IR on CA (small open economy)

Answer 8

Rise in r* causes C1 fall; S1 rise (SE>IE)
Rise in r* causes I1 fall
Movement along the schedules - no shift
CA improves

Question 9

Impact of rise in Q1 on CA (small open economy)

Answer 9

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

Question 10

Impact of future productivity shock on CA (small open economy)

Answer 10

A2 rises = investment schedule shifts right
A2 rises causes Q2 rise = C1 rises = S1 shifts left
At world IR, CA deteriorates

Question 11

Impact of expected future TT depreciation on CA (small open economy)

Answer 11

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

Question 12

IR risk premium for different countries

Answer 12

r1 = r* + p for debtors
r1 = r* for creditors

Question 13

Why must debtors offer at IR risk premium?

Answer 13

Higher risk of default
In order to encourage international investors to still buy their government bonds, must offer higher return
Therefore higher domestic IR

Question 14

Effect of constant risk premium on CA

Answer 14

Upwards shift of IR horizontal line

CA improves

Question 15

Effect of increasing risk premium on CA

Answer 15

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

Question 16

Equilibrium in large open economy

Answer 16

r1≠r*

CA US + CA ROW = 0

Question 17

Effect on IR and CA in closed economy of CA shifting left

Answer 17

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

Question 18

Effect on IR and CA in small open economy of CA shifting left

Answer 18

Large change in CA

No change in IR as = r* world IR which is given

Question 19

Effect on IR and CA in large open economy of CA shifting left

Answer 19

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.

Question 20

US CA huge deteriorate between

Answer 20

1996 to 2004

Question 21

2 alternative explanations for US CA deterioration

Answer 21

1. Made in USA hypothesis

2. Global savings glut hypothesis

Question 22

Explain made in USA hypothesis

Answer 22

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.

Question 23

Explain global savings glut hypothesis

Answer 23

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.

Question 24

3 reasons for global savings glut

Answer 24

1. Emerging markets accumulating foreign reserves to prepare to future crises & avoid 1990s experience.
2. Export-led growth due to ER manipulation (undervalued currency)
3. Foreign developed countries increased saving due to ageing population e.g. Japan

Question 25

How do IR change under Made in USA hypothesis

Answer 25

US want to borrow more = need to raise world IR so ROW saves more = higher IR

Question 26

How do IR change under global savings glut hypothesis

Answer 26

ROW increased saving = must incentivise US to borrow more = lower world IR

Question 27

Which hypothesis was correct in the data?

Answer 27

Data showed CA reversal which could be either.

But World IR fell = consistent with global savings glut hypothesis.

Question 28

Fisher’s equation

Answer 28

(1+rt) = (1+it)/Et Pit+1

Real IR = nominal IR - expected inflation

Question 29

Improved of US CA after 2006 explained by:

Answer 29

NOT due to subsiding of global savings glut, as in that case world IR would’ve risen, but they continued to fall.