Week 6 Current Account External Adjustment

Question 1

What is the functional form of Investment schedule and draw it

Answer 1

I1( r1 (-) , A2 (+))

Downward sloping investment.

Question 2

What is the functional form of savings schedule and draw it

Explain the reasoning behind this

Answer 2

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

Question 3

What shifts the savings schedule?
(Q?)

Answer 3

Increase in Q1 shifts saving to the right
Increase in Q2 shifts saving to the left

Question 4

1.How can we derive the CA schedule?

2.How do we draw the CA graphically?

Answer 4

1. 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.

2. 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

Question 5

How do you pin down what the CA is graphically?

Answer 5

You look for an exogenous interest rate, find interest rate and savings.

Then work out the difference between S and Investment.

Question 6

Why does CA graph have the shape it does

Answer 6

• Upward sloping as if interest rate is higher people will save more and invest less so S> I so that means CA increases.

Question 7

What is the graphical and rationale on a increase in the interest rate shock?

Answer 7

-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.

Question 8

What is the graphical and rationale on a a temporary increase in output shock?

Answer 8

-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.

Question 9

What is the graphical and rationale on a CA adjustment to increase in future productivity.

Answer 9

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

Question 10

What is the graphical and rationale on a future negative terms of trade shock.

Answer 10

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.

Question 11

What is interest rate risk premium?

Answer 11

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.

Question 12

What are the two types of interest rate premiums?

Answer 12

Constant premium: r* + p as soon as CA goes negative

Increasing premium r(-CA) as current account gets more negative risk premium increases.

Question 13

1.What is the set up of constant risk premium model

2.How do you draw a graph with constant risk premium?

Answer 13

1. if creditor r
   if debtor r + p
2. First draw initial interest rate as dotted line

Then increase interest rate by premium p and draw dotted horizontal line.

Question 14

What is the model for increasing risk premium?

Answer 14

r is a negative function of the current account and is increasingly negative.

This means the interest rate is a downward sloping.

Question 15

What is the implication of risk premium?

Answer 15

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.

Question 16

What is the implication of being a large economy and what is the model for CA?

Answer 16

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

Question 17

What is the implication of using the large open economy model?

Answer 17

It means lending by one economy must be matched by the same amount of borrowing by another country.

Question 18

What is the capital market clearing condition?

Answer 18

Interest rate must be one at which the CA of both countries is equal.

Question 19

What is the mechanism of the capital market clearing condition?

Answer 19

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.

Question 20

How do you set up the graph with the large economies impacting the interest rate?

Answer 20

Put R vertical line in middle.
On RHS is CA US
On LHS is CA ROW

CA ROW is mirror image of CA US.

Question 21

How do we graphically see how a CA decrease for 1 country impacts the world

Answer 21

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.

Question 22

How was the US CA tried to be explained?

Answer 22

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.

Question 23

Graphically how can the US CA deterioration be explained?

Answer 23

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.

Question 24

How do we explain the CA deterioration after finding the graphs?

How do we construct this?

So what is explained by the data?

Answer 24

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.

Question 25

What is the global savings glut for countries?

Answer 25

Because ROW wants to keep saving this means US will only borrow at a lower interest rate so keeps decreasing interest rate.