W4 - Economic shocks and the current account Flashcards
How do shocks alter the current account over time?
The current account balances of countries oscillate between deficits and surpluses over time generally as a response to economic shocks or changes
How does an increase in international interest rates impact an indebted country?
For an indebted country, both the income effect and the substitution effect cause a decrease in present consumption
How does an increase in international interest rates impact an indebted country’s current account?
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
How does an increase in international interest rates impact a lender country?
For a lender country the income effect and the substitution effects have oppostie effects on consumption in the first period
How does an increase in international interest rates impact a lender country’s current account?
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
How is government added to the model?
Government is added to the budget constraint rather than utility
What is assumed of government expenditure here?
The government collects taxes and uses them for public expenditures that do not affect the utility obtained from private expenditures
How do taxes impact the model?
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]
How does the inclusion of government in the model impact present and future consumption?
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
When would the slope of the budget constraint change?
When r changes
Why does adding government spending when it is equal across both periods not impact the current account balance?
Because the reduction in private consumption is exactly equal to the government expenditure
What happens to the CA balance if the government spends more in the first period?
It will lower the CA balance in the first period
What is the general rule for when the government will impact the CA balance?
The government will affect the CA balance if it alters the relative aggregate expenditures between the two periods
What are the two key determinants of the current account balance?
Savings and investment
What happens to the remaining capital after the second period?
As we are assuming only two periods, the consumer “disinvests” all they can in the last period
What are the steps of a consumer maximisation problem with production and investment included in the model?
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
How are the incentives to save and smooth consumption affected by the decision to invest?
The first order conditions show us that the incentives to save and smooth consumption are not effected by the decision to invest
What 3 factors increase the risk of a current account reveresal?
- 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
What factors make is less likely a country will experience a current account reversal?
- Openness to international trade
- Countries with more flexible exchange rates
Why is the negative impact of a current account reversal higher than their direct effect on investment in productive capacity?
Since the effect on investment is also substantial, the total effect of current account reversals on growth can be very large
Why do more open countries suffer less from current account reversals?
Because it is easier to increase exports or to get domestic expenditures to switch from imports to local products
Why do countries with flexible exchange rates suffer less from current account reversals?
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
How does Edwards define a sudden stop?
A sudden large reduction in capital flows. This might be caused by investors suddenly losing their appetite for that country’s debt or equity
