W4 - Economic shocks and the current account

Question 1

How do shocks alter the current account over time?

Answer 1

The current account balances of countries oscillate between deficits and surpluses over time generally as a response to economic shocks or changes

Question 2

How does an increase in international interest rates impact an indebted country?

Answer 2

For an indebted country, both the income effect and the substitution effect cause a decrease in present consumption

Question 3

How does an increase in international interest rates impact an indebted country’s current account?

Answer 3

There is a reduction in the current-account deficit in the first period which is measured as the difference between consumption and income. The indebtedness therefore decreases

Question 4

How does an increase in international interest rates impact a lender country?

Answer 4

For a lender country the income effect and the substitution effects have oppostie effects on consumption in the first period

Question 5

How does an increase in international interest rates impact a lender country’s current account?

Answer 5

The current-account surplus for the lender country increases if the substitution effect is stronger than the income effect; and decreases in the opposite case

Question 6

How is government added to the model?

Answer 6

Government is added to the budget constraint rather than utility

Question 7

What is assumed of government expenditure here?

Answer 7

The government collects taxes and uses them for public expenditures that do not affect the utility obtained from private expenditures

Question 8

How do taxes impact the model?

Answer 8

They are a lump sum and only affect consumption by reducing net income by exactly the amount of the tax [they do not distort any other decision]

Question 9

How does the inclusion of government in the model impact present and future consumption?

Answer 9

The inclusion of government does not change the rate of substitution between present consumption and future consumption: the slope of the consumer budget constraint remains unaltered

Question 10

When would the slope of the budget constraint change?

Answer 10

When r changes

Question 11

Why does adding government spending when it is equal across both periods not impact the current account balance?

Answer 11

Because the reduction in private consumption is exactly equal to the government expenditure

Question 12

What happens to the CA balance if the government spends more in the first period?

Answer 12

It will lower the CA balance in the first period

Question 13

What is the general rule for when the government will impact the CA balance?

Answer 13

The government will affect the CA balance if it alters the relative aggregate expenditures between the two periods

Question 14

What are the two key determinants of the current account balance?

Answer 14

Savings and investment

Question 15

What happens to the remaining capital after the second period?

Answer 15

As we are assuming only two periods, the consumer “disinvests” all they can in the last period

Question 16

What are the steps of a consumer maximisation problem with production and investment included in the model?

Answer 16

Equate consumption and income in the form of investment.
Rearrange this budget constraint to isolate C2.
Substitute C2 into the liftetime utility function
Takes the derivative of the utility function with respect to c1 and I1

Question 17

How are the incentives to save and smooth consumption affected by the decision to invest?

Answer 17

The first order conditions show us that the incentives to save and smooth consumption are not effected by the decision to invest

Question 18

What 3 factors increase the risk of a current account reveresal?

Answer 18

• Countries with large current account deficits relative to their GDP
• Countries with large external debts relative to their GDP
• Low level of international reserves or high debt to service to exports ratio

Question 19

What factors make is less likely a country will experience a current account reversal?

Answer 19

• Openness to international trade
• Countries with more flexible exchange rates

Question 20

Why is the negative impact of a current account reversal higher than their direct effect on investment in productive capacity?

Answer 20

Since the effect on investment is also substantial, the total effect of current account reversals on growth can be very large

Question 21

Why do more open countries suffer less from current account reversals?

Answer 21

Because it is easier to increase exports or to get domestic expenditures to switch from imports to local products

Question 22

Why do countries with flexible exchange rates suffer less from current account reversals?

Answer 22

Exchange rate depreciation lowers the relative price of local products: encourages exports and a switch from imports to local products; less risk of a currency crisis

Question 23

How does Edwards define a sudden stop?

Answer 23

A sudden large reduction in capital flows. This might be caused by investors suddenly losing their appetite for that country’s debt or equity