W3 - Optimum current account levels Flashcards
Is the current account determined by the exchange rate?
The current account is not determined by the exchange rate but rather domestic forces such as savings.
What is beta in the model?
The intertemporal discount factor, it measures the degree of consumer patience. The higher beta, the more patient you are meaning you value future consumption a lot
If you borrow 1 unit of the good today, how much of the good can you consume tomorrow?
If you borrow 1 unit today, you consume 1+r less tomorrow
What is the slope of the indifference curve?
The marginal rate of substitution
What does the MRS show?
The level of consumption you give up tomorrow for more today showing your preference
If you save 1 unit of the good today, how much of the good can you consume tomorrow?
If you save 1 unit of the good today, you consume an extra 1+r units of the good tomorrow.
What does the intertemporal budget constraint establish?
That the present value of consumption should be equal to the present value of income
How does a consumer decide their consumption?
Subject to the inter-temporal budget constraint
What is the name of the first order condition for a level of consumption that maximises utility?
Euler Equation
What is the slope of the budget constraint?
-(1+r)
How can the consumer further increase utility?
By reallocating consumption between periods
What is the relative price?
The cost of current consumption (giving up interest rate r). Consumption tomorrow v today
Where does the consumer maximise utility?
Maximises utility subject to the budget constraint when the MRS of consumption between the two period is equal to its relative price
To find the value of consumption for each period, what do we need to know?
The functional form of u, the value of beta and r
What happens if beta=1/1+r?
Consumption in period 1 will be the same as in period 2
What condition needs to be satisfied for there to be consumption smoothing?
Access to credit markets
What is the optimal condition?
C1=C2
Without G or I, what is the CA balance dependent on?
Only the decision to save.
Positive savings = positive CA balance and the country lends
Negative savings = negative CA and the country borrows
What are the exogenous factors in this model?
y1, y2 and r
Which are the endogenous variables in the model?
c1 and c2
What is the discount rate given by to have consumption smoothing?
The interest rate
If you have a high g, what should you do?
The best strategy is to go into debt in the present. In the future, the country will have a greater income and be able to pay its debt without reducing its consumption levels
Why is the interest rate higher in autarky under a deficit?
Since consumers would choose to borrow in the first period if they had access to the international capitals market, a higher interest rate is required in autarky to induce them not to borrow
Why do consumers gain from being part of international markets?
Because of the ability to smooth consumption
Why do current account balances oscillate between deficits and surpluses over time?
These movements are generally responses to economic shocks or changes
What does the international interest rate represent?
The relative price between present and future consumption
What does an increase in international interest rates do to consumption in the intertemporal model?
An increase in the international interest rates causes present consumption to be relatively more expensive. From the Euler equation a higher r leads to lower present consumption relative to future consumption. This is the substitution effect of higher interest rates
What is the income effect of the interest rate on consumption?
The income effect from an increase in interest rates implies a rise in consumption for lender countries and a reduction for borrower countries
What does an increase in interest rates do to a indebted country?
Both the income effect and the substitution effect cause a decrease in present consumption reducing the CA deficit in the first period decreasing indebtedness
What does an increase in interest rates do to a lender country?
The income effect and the substitution effects have opposite effects on consumption in the first period
How do permanent increase in income effect the CA balance?
Permanent output shocks do not alter the CA balance while positive temporary shocks increase it
How does a higher interest rate impact Beta?
A higher interest rate lowers your beta
