TERM 1: Uncertainty & CA

Question 1

Why may there be uncertainty?

Answer 1

Agents do not know the value of Q2 exactly as of period 1 time.

Question 2

What is the Great Moderation?

Answer 2

Huge structural break in uncertainty in countries across the world in 1984. GDP volatility reduced massively and have remained low since.

Question 3

What else happened in mid-1980s? What then do we want to find out?

Answer 3

CA decreased as a fraction of GDP.
Correlation between low uncertainty & low CA.
But causation?

Question 4

4 assumptions for simlplicity

Answer 4

1. Q1 = Q2 = Q
2. Log preferences
3. B0* = 0
4. r*=0

Question 5

Without uncertainty, constant endowment, zero assets and zero IR, what is equilibrium?

Answer 5

C1* = C2* = Q.
TB1 = CA1 = 0
- No role for consumption smoothing

Question 6

2 possible values of Q2 with uncertainty

Answer 6

Q2 good state = Q + sigma p=0.5

Q2 bad state = Q - sigma p=0.5

Question 7

Utility function adding uncertainty

Answer 7

U = ln(C1) + Eln(C2)

Expectation operator

Question 8

What do we expect Q2 to be?

Answer 8

Still expect Q2 = Q, however the realisation may be Q2≠Q

Question 9

Budget constraint in good and bad states

Answer 9

C2 = 2Q + sigma - C1
C2 = 2Q - sigma - C1

Question 10

Utility function in terms of C1 only

Answer 10

U = ln(C1) + 1/2ln(2Q+sigma-C1) + 1/2ln(2Q-sigma-C1)

Question 11

FOC

Answer 11

1/C1 = 1/2[1/(2Q+sigma-c1) + 1/(2Q-sigma-c1)]

Question 12

Is C1=Q still a solution?

Answer 12

Only when sigma=0 i.e. no uncertainty

Question 13

When sigma >0, what is C1, TB1, CA1

Answer 13

C10; CA1>0

Question 14

A concave utility function implies…

Answer 14

RISK AVERSION: loss of utility from bad state > gain in utility from good state despite symmetric change.

Question 15

Impact of uncertainty on saving

Answer 15

Higher uncertainty = greater precautionary incentive ti save

Question 16

Therefore, impact of uncertainty on CA

Answer 16

lower uncertainty after 1984 CAUSED worsening of CA as less precautionary saving.