Week 6 Current Account External Adjustment Flashcards
What is the functional form of Investment schedule and draw it
I1( r1 (-) , A2 (+))
Downward sloping investment.
What is the functional form of savings schedule and draw it
Explain the reasoning behind this
S1 = S( r1(+), Q1(+), Q2(-))
upward sloping straight line
As you want to smooth consumption if you get more Q1 then you save it for next period
If you get more Q2 you borrow to consume more in period 1
What shifts the savings schedule?
(Q?)
Increase in Q1 shifts saving to the right
Increase in Q2 shifts saving to the left
1.How can we derive the CA schedule?
2.How do we draw the CA graphically?
- CA = S - I if savings
CA(r) = S(r) - I(r)
If savings are higher these must go abroad
if investment is higher than saving then it must be borrowed from abroad.
- on one side draw the investment and saving on one graph.
Then draw the CA which is at each point the difference between saving and investment. Vertical line down where S = I
How do you pin down what the CA is graphically?
You look for an exogenous interest rate, find interest rate and savings.
Then work out the difference between S and Investment.
Why does CA graph have the shape it does
- Upward sloping as if interest rate is higher people will save more and invest less so S> I so that means CA increases.
What is the graphical and rationale on a increase in the interest rate shock?
-Graphically r moves upwards so the current account improves (movement on CA)
-Higher r through substitution effect increases savings and depresses investments. This improves the CA.
What is the graphical and rationale on a a temporary increase in output shock?
-Investment schedule does not change
-Savings schedule shifts out as an increase in Q1 causes an increase in saving due to consumption smoothing.
Therefore at the interest rate does not change the CA shifts out.
Therefore this leads to a CA improvement, as savings improve and investment does not change.
What is the graphical and rationale on a CA adjustment to increase in future productivity.
Increase in future productivity impacts A2
This causes investment to shift right as gives higher I1 incentive
Savings will shift left.
Then as higher I1 means higher Q2, consumer will consume more in Q1 to smooth consumption.
Overall this makes the gap between savings and investment bigger than it originally was which decreases CA.
So the CA shifts left for the same level of interest
What is the graphical and rationale on a future negative terms of trade shock.
Terms of trade negative shock is the same as negative Q2 shock.
As Q2 will be lower they want to smooth consumption, so Q1 saving increases. So S1 shifts right.
This decreases distance between Q and I.
What is interest rate risk premium?
if you ask a bank for a loan, the more you borrow the more risky it is for them to lend so they may add a premium to the r.
What are the two types of interest rate premiums?
Constant premium: r* + p as soon as CA goes negative
Increasing premium r(-CA) as current account gets more negative risk premium increases.
1.What is the set up of constant risk premium model
2.How do you draw a graph with constant risk premium?
- if creditor r
if debtor r + p - First draw initial interest rate as dotted line
Then increase interest rate by premium p and draw dotted horizontal line.
What is the model for increasing risk premium?
r is a negative function of the current account and is increasingly negative.
This means the interest rate is a downward sloping.
What is the implication of risk premium?
It makes the country more sensitive to taking on more debt or making the CA more negative.
If you want to increase debt you will do so at a lower rate compared to if there was no premium.
What is the implication of being a large economy and what is the model for CA?
As economy is large it impacts world interest rate
This means the CA impacts the interest rate for the world.
CA(r) + CA row (r) = 0W
What is the implication of using the large open economy model?
It means lending by one economy must be matched by the same amount of borrowing by another country.
What is the capital market clearing condition?
Interest rate must be one at which the CA of both countries is equal.
What is the mechanism of the capital market clearing condition?
US wants to borrow more:
But for equilibrium CA us = CA row.
So ROW want higher interest rate if they have to lend more, whilst US wants to borrow more than it would ideally as it is higher interest rate.
How do you set up the graph with the large economies impacting the interest rate?
Put R vertical line in middle.
On RHS is CA US
On LHS is CA ROW
CA ROW is mirror image of CA US.
How do we graphically see how a CA decrease for 1 country impacts the world
Original equilibrium A
US wants to borrow more (C) as the same interest rate.
However, this is in a disequilibrium.
ROW is not happy to lend at this interest rate.
Two force, ROW will provide lending at higher r
US will want to borrow less at a higher r
So in order for ROW to lend more it will only do so at a higher interest rate. As the interest rate is higher the US also wants to borrow less than it would have at a lower interest rate.
How was the US CA tried to be explained?
The US CA deterioration was tried to be explained in two ways by Bernanke:
Made in US: it was due to the internal factors in US eg housing boom that made people want to invest more and save less.
Outside US: due to the actions of non-US countries like depreciating their currency for export-led growth and buying US debt which.
Graphically how can the US CA deterioration be explained?
Two graphs with two things going on:
Graph 1:
CA US shifts to left and gets more negative
(r) increases
Graph 1
CA of ROW shifts to right as they save more (r) decreases.
How do we explain the CA deterioration after finding the graphs?
How do we construct this?
So what is explained by the data?
We explain it by computing the interest rate.
We construct it by
1+rt = (1+it)/ expected inflation +1
Data points to global savings glut.
What is the global savings glut for countries?
Because ROW wants to keep saving this means US will only borrow at a lower interest rate so keeps decreasing interest rate.
