Week 3- Theory Of Current Account Determination

Question 1

What does a small open economy mean?

Answer 1

Small means world prices and the interest rates are independent of domestic economic conditions. Open means trade is allowed in periods 1 and 2.

Question 2

What is the equation for the intertemporal budget constraint and what does it imply

Answer 2

C1+C2/1+R1=(1+Ro)B*o + Q1 + Q2/1+R1. This implies that the present discounted value of the endowment plus the initial wealth (RHS) must be enough to pay for the present discounted value of consumption.

Question 3

Why is the slope of the Inter-temporal Budget constraint -(1+R1)

Answer 3

Slope is -(1+R1) because if you sacrifice one unit of consumption and put it into the bank you get a return of 1+R1 units in the next period.

Question 4

What is the condition for optimal consumption?

Answer 4

-U’(C1)/U’(C2)= - (1+R1)

Question 5

What is the optimal consumption bundle equal to and what does this imply?

Answer 5

1/2(1+Ro)Bo+Q1+Q2/1+R1. According to this expression, consumption is increasing in Q1 ,Q2 and (1+Ro)Bo and decreasing the interest rate R1

Question 6

What happens to consumption if the increase in Q1 is temporary so that Q2 is not expected to change?

Answer 6

Consumption will increase by 1/2 the change in output and leave the other half for future consumption.

Question 7

What happens if the increase in Q1 is expected to be associated with an equal increase in Q2?

Answer 7

Household consumes all of it as there is no point leaving it for next time as there is an equal increase.

Question 8

What are the 2 equations for the optimal trade balance in a 2-period economy?

Answer 8

TB=Q1-C1

TB1=1/2(-(1+Ro)B*o+Q1-Q2/1+R1

Question 9

What are the 2 equations for the optimal current account?

Answer 9

CA1=TB1 + RoBo

CA=1/2{-(1-ro)B*o+Q1-Q2/1+R1

Question 10

What does it mean if we assume there is free capital? mobility and the free determination of the interest rate?

Answer 10

Households are able to borrow and lend in the international financial markets. Let R* be the world interest rate than free capital-labour mobility guarantees that the domestic interest rate R1 must equal the word interest rate otherwise unlimted profit could be made by borrowing in the international market and lending in the domestic one.

Question 11

What are the effects of a temporary output shock?

Answer 11

The current account will improve by half the increase in output. Households know the output increase is temporary and because they like to smooth consumption over time they save half of it for the next period.

Question 12

What are the effects of a permanent output shock?

Answer 12

All is consumed because you know the output shock in period 1 will be the same as the output shock in period 2 so you will choose to consume more in both periods.

Question 13

Explain how an economy will adjust to output shocks in the economy?

Answer 13

Finance temporary output shocks by running CA deficits or surpluses without much change in spending.
Adjust to permanent output shocks by changing spending without much change in the current account

Question 14

What does the terms of trade measure?

Answer 14

The relative price of exportable goods to importable goods. TT=Px/Pm

Question 15

What is the new Intertemporal Budget Constraint when taking into account the terms of trade and explains what this means?

Answer 15

C1+C2/(1+r1)=(1+Ro)B*o+TT1Q1 + TT2Q2/(1+r1)
Same as the original IBC apart from endowments Q1 and Q2 are replaced by TT1Q1 TT2Q2. Multiplying Q1 by TT1 we are expressing the endowment of exportable goods in terms of importable goods so that all the terms are in the same unit.

Question 16

Explain the effects of temporary and permanent terms of trade shocks on the trade balance and the current account?

Answer 16

The temporary shock will tend to have large effects on the trade balance and the current account, and permanent terms of trade shocks will have a much smaller effect.

Question 17

How would you finance temporary and permanent terms of trade shocks?

Answer 17

Finance temporary shocks by running CA deficits or surpluses without much change in spending.
Finance pernament terms of trade shocks by changing spending without much change in the current account.

Question 18

What are the two effects of an interest rate shock, and which one has a greater effect?

Answer 18

1. The Substitution effect: An increase in the IR makes savings much more attractive to households so they are more likely to substitute present consumption with future consumption. As a result, consumption falls and the TB and CA improve.
2. Wealth Effect: An increase in the IR makes debtors poorer and creditors richer

Question 19

Show on a diagram the adjustment to a world interest rate shock of an increase in R* and explain this diagram

Answer 19

-See notes for the diagram

Question 20

What is the reason for governments implementing capital controls and what are the 2 ways they do this by?

Answer 20

Governments implement Capital controls to try and prevent CA deficits by causing debt to increase and reducing consumption in the future. This can be done by prohibiting international borrowing and taking international borrowing.

Question 21

Draw the equilbirum under capital controls and explain the diagram?

Answer 21

-See notes

Question 22

What will the R1 eventually equal to in an economy under capital controls

Answer 22

R1=Q2/Q1 -1