W3 - Optimum current account levels

Question 1

Is the current account determined by the exchange rate?

Answer 1

The current account is not determined by the exchange rate but rather domestic forces such as savings.

Question 2

What is beta in the model?

Answer 2

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

Question 3

If you borrow 1 unit of the good today, how much of the good can you consume tomorrow?

Answer 3

If you borrow 1 unit today, you consume 1+r less tomorrow

Question 4

What is the slope of the indifference curve?

Answer 4

The marginal rate of substitution

Question 5

What does the MRS show?

Answer 5

The level of consumption you give up tomorrow for more today showing your preference

Question 6

If you save 1 unit of the good today, how much of the good can you consume tomorrow?

Answer 6

If you save 1 unit of the good today, you consume an extra 1+r units of the good tomorrow.

Question 7

What does the intertemporal budget constraint establish?

Answer 7

That the present value of consumption should be equal to the present value of income

Question 8

How does a consumer decide their consumption?

Answer 8

Subject to the inter-temporal budget constraint

Question 8

What is the name of the first order condition for a level of consumption that maximises utility?

Answer 8

Euler Equation

Question 9

What is the slope of the budget constraint?

Answer 9

-(1+r)

Question 10

How can the consumer further increase utility?

Answer 10

By reallocating consumption between periods

Question 11

What is the relative price?

Answer 11

The cost of current consumption (giving up interest rate r). Consumption tomorrow v today

Question 12

Where does the consumer maximise utility?

Answer 12

Maximises utility subject to the budget constraint when the MRS of consumption between the two period is equal to its relative price

Question 13

To find the value of consumption for each period, what do we need to know?

Answer 13

The functional form of u, the value of beta and r

Question 14

What happens if beta=1/1+r?

Answer 14

Consumption in period 1 will be the same as in period 2

Question 15

What condition needs to be satisfied for there to be consumption smoothing?

Answer 15

Access to credit markets

Question 16

What is the optimal condition?

Answer 16

C1=C2

Question 17

Without G or I, what is the CA balance dependent on?

Answer 17

Only the decision to save.

Positive savings = positive CA balance and the country lends
Negative savings = negative CA and the country borrows

Question 18

What are the exogenous factors in this model?

Answer 18

y1, y2 and r

Question 19

Which are the endogenous variables in the model?

Answer 19

c1 and c2

Question 20

What is the discount rate given by to have consumption smoothing?

Answer 20

The interest rate

Question 21

If you have a high g, what should you do?

Answer 21

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

Question 22

Why is the interest rate higher in autarky under a deficit?

Answer 22

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

Question 23

Why do consumers gain from being part of international markets?

Answer 23

Because of the ability to smooth consumption

Question 24

Why do current account balances oscillate between deficits and surpluses over time?

Answer 24

These movements are generally responses to economic shocks or changes

Question 25

What does the international interest rate represent?

Answer 25

The relative price between present and future consumption

Question 26

What does an increase in international interest rates do to consumption in the intertemporal model?

Answer 26

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

Question 27

What is the income effect of the interest rate on consumption?

Answer 27

The income effect from an increase in interest rates implies a rise in consumption for lender countries and a reduction for borrower countries

Question 28

What does an increase in interest rates do to a indebted country?

Answer 28

Both the income effect and the substitution effect cause a decrease in present consumption reducing the CA deficit in the first period decreasing indebtedness

Question 29

What does an increase in interest rates do to a lender country?

Answer 29

The income effect and the substitution effects have opposite effects on consumption in the first period

Question 30

How do permanent increase in income effect the CA balance?

Answer 30

Permanent output shocks do not alter the CA balance while positive temporary shocks increase it

Question 31

How does a higher interest rate impact Beta?

Answer 31

A higher interest rate lowers your beta