Week 6 - External Adjustment in Small and Large Economies

Question 1

What is the investment schedule and explain how the components are a +ve or -ve function.

Answer 1

I1=I(r1 : A2)

• Interest rate is a negative function, higher interest rate means higher costs, which disincentives investment.
• A2 is a +ve function, higher efficency means higher R.O.I which increases the incentive to invest.

Question 2

What is the saving schedule and explain how the components are are a +ve or -ve function.

Answer 2

• r1- This is a positive function the higher the interest rate the higher the reward for saving therefore the greater incentive to save.
• Q1- This is a positive function. A temporary increase in Q1 means the consumer has more wealth, however because the consumer prefers to smooth his consumption, this leads to the consumer saving more and not matching their current consumption level with their current endowment.
• Q2- This is a negative function. An increase in endowment in the second period will lead to less saving as there is no incentive for the consumer to save.

Question 3

On a graph does the saving schedule shift left or right when Q1 increases and when Q2 increases

Answer 3

• An increase in Q1 shifts the saving schedule curve to the right.
• An increase in Q2 shifts the saving schedule curve to the left.

Question 4

What is the relationship between the current account, saving and investment, and explain the intuition behind the equation.

Answer 4

• CA = S - I
• If investment is greater than saving then it means money has been borrowed from financial markets in order to invest, this leads to a negative current account.
• If saving is greater than investment it means that the extra saving is used to invest in assets abroad which leads to a positive current account.

Question 5

What is the current account schedule equal to?

Answer 5

CA(r) = S(r) - I(r), Current account schedule is the difference between the saving and investment schedule.

Question 6

Draw a savings investment schedule graph and show were the current account lies

Answer 6

Draw graph Y axis R, X axis S/I. The current account is the difference between the savings and investment graph.

Question 7

Draw the graph for current account determination in a small open economy

Answer 7

Small economy therefor r=r, with r being the world interest rate

X axis = CA, Y axis = r1 Interest rate R* fixed horizontal line CA line sloping upwards. When CA line and Interest rate meet that is the CA.

Question 8

Explain what happens to the current account following an increase in the interest rate, both theoretically and on a diagram

Answer 8

• Theoretically: An increase in the interest rate leads to more savings due to the substitution effect, which causes the savings curve to shift to the right, investment falls because higher interest rates increase the cost. As a result the difference between the investment and savings curve is much smaller than before meaning an improvement in the CA

Question 9

Explain what happens to the current account following a temporary output shock, both theoretically and on a diagram

Answer 9

Investment remains unchanged as investment in period 1, is not affected by the endowment in period 1 as its a forward looking function that only cares about the second part. This means investment is unchanged and therefore doesn’t change so there is also no change on the diagram for investment.

Saving increases and therefore shifts right on the diagram, as households do not match their current consumption to their current endowment, instead they save for of the resources for the next period leading to a shift right in saving.

This overall lowers the current account deficit as the difference between I and S is much lower.

Question 10

Explain what happens to the current account following a future increase in productivity both theoretically and on a diagram.

Answer 10

• Investment - Higher productivity means higher efficiency of machines which incentivises investment leading to an increase in investment and a shift right of the investment curve.
• Saving - Increases efficiency means higher profit for firms in period 2, which will mean consumers expect higher incomes in period 2. As a result in order to smooth consumption over time consumers will save less or borrow more in the first period as they are confident of an increase in income leading to a fall in saving and hence the saving curve shifting to the left.
• This results in an increase in the current account deficit as saving only shift to the right by a very small amount.

Question 11

Explain what happens to the current account following an expected future terms of trade depreciation both theoretically and on a diagram.

Answer 11

• ToT depreciation can be treated the same way as negative income shock, as a depreciation of the ToT leads to a fall in he value of exports and hence a fall in future income.
• Savings - Savings increase resulting into a shift to the right of savings, as in order to prepare for the future negative income shock consumers will save in the current period.
• Investment - No changes
• This leads to a fall in the current account deficit.

Question 12

What is a interest rate premium, and who is it given to?

Answer 12

Interest rate premiums are an extra cost you specifically have to pay. The more a country is in debt the less likely creditors will give them credit at low cost and will therefore have a premium.

Question 13

What is the interest rate for a creditor and for a debtor

Answer 13

• Creditor r1= r*
• Debtor r1 = r* + p
• P = The countries risk premium P = r1- r*

Question 14

What happens to the current account if there is a constant risk premium?

Answer 14

The current account deficit will be lower, as its more expensive for the country to run a large deficit.

Question 15

What happens to the current account if there is a increasing risk premium?

Answer 15

The premium is a negative function of the current account which means it has a negative slope. Therefore the higher the CA deficit the the higher the interest rate premium needed to be paid. This will therefore disincentives countries to run large current account deficits

Question 16

Explain how a shock affects the current account of the US and the ROW in a large open economy. Assume there is a negative shock in the US

Answer 16

• Diagram will explain it see notes
• CA us is slightly -ve, while CA row is slightly positive they are a mirror image of one another of the same magnitude. A shock to the US current account will lead to a leftwards shift of the CA increasing the CA deficit. This will then lead to a higher IR as the US is in further debt and the premium will increase. The ROW is happy to continue charging these high rates, however the US wants to borrow less which forms a new equilibrium at point B.

Question 17

What did Bernanke observe, and briefly explain the hypothesis he suggests about this observation?

Answer 17

• Observed that between 1996 and 2004, the US Current account greatly depreciated
• Hypothesis 1: The made in the US hypothesis - The deterioration of the CA reflects developments in the US and is independent of developments elsewhere. Suggests the US decided to save less and invest more due to financial innovation such as over-investment in housing which leads to a deterioration of the CA.
• Hypothesis 2: The CA deterioration was due to external factors that are due to developments in the RoW. Suggests it was due to a ‘global saving glut’ which was a significant increase in the global supply of savings leading to the current account schedule shifting down and left.

Question 18

What is the only way to distinguish between the two Bernanke hypothesis?

Answer 18

By observing what happens to the interest rate, the made in the US hypothesis predicts that the IR rise’s, while the global saving glut predicts the IR falls.

Question 19

What is the real interest rate equal to?

Answer 19

1 + rt = (1 + it) / Et Pie t + 1, which says the real interest rate equals the nominal interest rate divided by the expected inflation.

Question 20

Which of the two of the Bernanke hypothesis is observed to be true in the real world?

Answer 20

Figures show that the real interest rate has fallen over time which is consistent with the global Global saving glut hypothesis.