nternational Monetary Economics
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Topic22021.pptxTOPIC 2 THE INTERTEMPORAL MODEL OF THE CURRENT ACCOUNT
A Two Period Budget Constraint
The Intertemporal Model
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Recall: National Income Account
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If Sn > I CA > 0 ∆NFA > 0
Balance of Trade Surplus EX>IM
Current Account Surplus
Net Foreign Asset (Net Foreign Wealth) Increasing
Financial Account Deficit
Capital Outflow
Lending Surplus savings to the Rest of the World
If Sn < I CA < 0 ∆NFA < 0
Balance of Trade Deficit EX<IM
Current Account Deficit
Net Foreign Debt Increasing
Financial Account Surplus
Capital Inflow
Borrowing savings from the Rest of the World
Article Link RBA Covid response
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Learning outcomes – Topic 2
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Explain
Explain the intertemporal dimension of decisions made by economic agents in an international macroeconomic setting.
Explore
Explore the relationship between the closed economy and world interest rate and the current account balance within an intertemporal framework.
Analyse
Analyse the potential gains from cross border flows of financial assets.
Evaluate
Critically evaluate whether current global imbalances are consistent with the intertemporal model.
INTER-TEMPORAL MODEL: The Inter-temporal Production Possibility Frontier
For any economy, there is a trade-off (opportunity cost) between consuming today and saving for the future: resources can either be consumed or saved.
To save and invest more today typically means that economies need to consume less today.
To consume more today typically means that economies have to borrow today and repay in the future
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What is the relative price of current consumption?
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We represent this concept by drawing a special kind of production possibility frontier, an intertemporal production possibility frontier.
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The two-period intertemporal budget constraint
The equation below is the two-period intertemporal budget constraint. It tells us that a country’s initial net foreign asset position must equal the present discounted value of its future trade deficits.
W0 = –NX1/(1+r) - NX2/(1+r)2
A country with positive initial net foreign wealth (a creditor country) can afford to run trade deficits “on average” in future; conversely a country with negative initial net wealth (a debtor country) is required to run trade surpluses “on average” in future.
Refer to this article for some insights
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INTERTEMPORAL MODEL
We can illustrate a simplified model of the macroeconomy to identify the macroeconomic gains from opening the economy up to the rest of the world, from the perspective of consumption smoothing and efficient investment.
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INTERTEMPORAL MODEL
In a closed economy current consumption can be increased only through internal means
More of the economy’s domestic resources can be allocated to produce current consumption. This means that savings and therefore investment are decreased which means future consumption is reduced.
The cost of increasing current consumption in this way depends on the marginal return on investment
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INTERTEMPORAL MODEL
Let rc = real rate of interest in a closed economy.
Assume there is only one market rate of interest
is the price of current consumption in terms of future consumption forgone
e.g. if rc =8% (0.08), then the cost of 1 unit of current consumption (Co) is 1.08 units of future consumption.
rc reflects both the marginal rate of return on private investment and the marginal rate of time preference (MRTP).
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INTERTEMPORAL MODEL
In a closed economy future consumption can only be increased through internal means
Increase domestic investment which requires an increase in savings and therefore a decrease in current consumption. The cost of increasing future consumption is reduced current consumption
is the price of future consumption in terms of current consumption forgone
e.g. if rc =8% (0.08), then the cost of 1 unit of future consumption is 0.926 units of current consumption
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INTER-TEMPORAL MODEL: Notes The relative price of current consumption?
The price of borrowing 1 unit of output/income to consume today is the output/income that needs to be repaid in the future:
principal + interest = 1+r, where r is the real interest rate
Alternatively, the opportunity cost of consuming 1 unit of output/ income today is the output/income that could be earned by saving it:
principal + interest = 1+r, where r is the real interest rate
The trade-off is one unit of current consumption for (1+r) units of future consumption ↔ The opportunity cost of current consumption relative to future consumption is (1+r)
The relative price of current assumption in terms of future consumption (1+rc)
The relative price of future consumption in terms of current consumption is 1/(1+rc)
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INTERTEMPORAL MODEL
Firms will continue to invest in physical capital until the marginal rate of return equals rc .
An individual’s MRTP is the rate at which the consumer is willing to give up a small amount of current consumption to obtain more consumption in the future.
Alternatively, it is the rate at which the consumer is willing to forgo future consumption to obtain a marginal increase in current consumption.
Given efficient capital markets, a rate of interest of rc implies that an individual is indifferent between having Co units of consumption in this period and (1+r) Co next period.
Why?
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INTERTEMPORAL MODEL
MRTP is not a constant, but depends on the marginal utility of current and future consumption.
If their MRTP > rc they would borrow at rc and consume more in the current period, and the marginal utility of current consumption would fall until their MRTP = rc ;
if MRTP < rc they would save and their marginal utility of current consumption would increase until their MRTP = rc
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Open Economy, INTERTEMPORAL MODEL
In an open economy current consumption can be increased through external means
Current consumption can be increased through running a balance of trade deficit.
A balance of trade deficit is financed by a financial account surplus.
Therefore the cost of increasing current consumption in this way depends on the marginal cost of foreign borrowing.
Let r = real rate of interest in an open economy
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In an open economy future consumption can be increased through external means
The domestic economy can continue to use its resources to produce current consumption goods, but instead of consuming them directly them will export them. The economy can therefore run a balance of trade surplus which is counter balanced by a financial account deficit. In future periods, the foreign economy will have to repay the borrowing which will enable to domestic economy to increase future consumption.
The cost of increasing future consumption this way is the return that could have been earned on domestic investment.
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Open Economy INTERTEMPORAL MODEL
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Metzler Diagram
In a closed economy rc is determined by Saving (S) and Investment (I). Savings always equals investment in a closed economy.
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Savings
Savings means an increase in the amount of current consumption foregone.
Individuals are prepared to save (reduce current consumption) as long as they are compensated by increased future consumption.
They will makes resources available today for a price, the real rate of interest.
The greater the amount of saving that takes place the greater the required reward for refraining from an additional unit of current consumption
The area under the savings curve indicates the “cost of saving”. If savings increases the cost of the additional savings is the area under the savings curve between the old and new levels of savings.
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Savings
The area under the savings curve indicates the “cost of saving” C0
If savings increases the cost of the additional savings is the area under the savings curve between the old and new levels of savings.
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rc
S, I
S
I
Sa → S0
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Investment
Investment enables an increase in (future) consumption.
The real rate of interest is the return (for the sacrifice of current consumption) that investment can generate.
The greater the amount of investment that takes place the lower the return from undertaking an additional unit.
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Investment
The area under the investment curve is the net return from investment. – C1
If investment increases the area under the investment curve between the old and new levels of Investment indicate the size of the gain.
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rc
S, I
S
I
Ia → I0
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Gains from Inter-temporal trade: Metzler Diagram
In a closed economy rc is determined by Saving (S) and Investment (I). Savings always equals investment in a closed economy.
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rc
S, I
S
I
rc
S, I
S
I
Sa → S0
Ia → I0
Cost of saving
(cost of forgone current consumption)
Return from investment
(benefit of increased future consumption)
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Closed Economy Rc < World interest rates
If rc < r then the country will run a current account surplus and will be a net lender to the rest of the world.
The return on lending overseas is greater than the rate at which consumers are willing to sacrifice current consumption for future consumption.
The return on lending overseas is greater than the forgone domestic return on investment in physical capital.
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Closed Economy Rc > World interest rates
If rc > r then the country will run a current account deficit and will be a net borrower from the rest of the world.
The rate at which consumers are willing to forgo future consumption to obtain a marginal increase in current consumption is greater than the cost of foreign borrowing.
The return on additional domestic investment is greater than the cost of foreign borrowing
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Small Country Worked Example
Assume a small closed economy has the following saving and investment schedules
IA= 22-2r
SA=0.5r +4. 5
(r is expressed as a percentage)
Since the economy is closed
IA= SA
22-2r = 0.5r +4.5
rA = 7%
The level of investment and saving in economy A are both equal to 8
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CASE 1: A SMALL ECONOMY AND A LOWER WORLD REAL RATE OF INTEREST
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SA
IA
7%
8
5%
12
7
r
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CASE 1: A Lower World Real Rate of Interest
If the economy is opened up to the rest of the world and since it is small it can’t effect the world real interest rate, which we assume is 5%.
This means economy A can obtain as much saving as it wants from the rest of the world at a price less than it has to pay savers domestically ( 7%).
The level of domestic savings reduces by 1 (from 8 to 7) as the compensation/reward for domestic savings has been reduced to 5%
Domestic investment increases by 4 (from 8 to 12) as projects that yield a return less than 7% become viable, as the level of domestic investment increases the marginal return on domestic investment decreases.
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CASE 1: A Lower World Real Rate of Interest
At the prevailing world real rate of interest of 5% with IA > SA the economy is running a Current Account deficit of 5, which it finances through running a Financial Account surplus.
We will now examine separately the effect of the increase in the level of domestic investment and the reduction in domestic savings.
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The Increase in Investment
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SA
IA
7%
8
5%
12
7
r
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Investment increases from 8 to 12 at the same time that domestic savings decreases from 8 to 7. Therefore the increase in investment of 4 must be financed by foreign borrowings.
The return from the increased domestic investment ( the area underneath the investment curve between 8 and 12) is greater than the cost of the foreign borrowings (the area underneath the horizontal world real interest rate curve between 8 and 12) so the economy gains.
The Decrease in Savings
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Savings decreases from 8 to 7 at the same time that domestic investment increases.
Therefore the decrease in domestic savings is offset by an increase in foreign borrowings.
As the cost of foreign borrowings (the area underneath the horizontal world real interest rate curve between 7 and 8) is less than the benefit of being able to reduce domestic savings ( the area underneath the domestic savings curve between 7 and 8) the economy gains.
Gains from Inter-temporal trade: Metzler Diagram – A small economy and a lower world real rate of interest
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S
I
At rc; S = I; CA = 0
At r1 < rc: I > S; CA < 0 ↔ ∆NFL > 0
Cost of ∆NFL = r1 (∆NFL) = area C + D
Part of ∆NFL finances increased investment ∆I
→ Return on ∆I = area B + D
The net benefit from ∆I = area B
Part of ∆NFL finances increased consumption (reduced saving) ∆C = - ∆S
→ Benefit from ∆C = area A + C
The net benefit from ∆C = A
The total gain = A + B
A
B
C
D
rc
r1
I1
S1
ΔNFL > 0
∆I
r
I0
-∆S
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CASE 2. A Higher World Real Rate of Interest
If the economy is opened up to the rest of the world and since it is small it can’t effect the world real interest rate, which we now assume is 10%.
This means economy A can lend as much of its domestic savings as it wants to rest of the world at a price greater than that required by its domestic savers and a return greater than the marginal return on domestic investment (7%).
As a result the level of domestic investment decreases by 6 (from 8 to 2) for with the higher real rate of interest only those investments that yield a return greater than 10% are now worth undertaking.
At the higher real rate of interest (10%) domestic savings increases by 1.5 (from 8 to 9.5) as there is a higher compensation for refraining from current consumption.
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CASE 2. A Higher World Real Rate of Interest
At the prevailing world real rate of interest of 10% with IA < SA the economy is running a Current Account Surplus of 7.5, which it uses to run a Financial Account deficit.
We will now examine separately the effect of the increase in the level of domestic investment and the reduction in domestic savings.
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CASE 2: A SMALL ECONOMY AND A HIGHER WORLD REAL RATE OF INTEREST.
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SA
IA
7%
8
r
10%
2
9.5
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The Increase in the Domestic level of Savings
The domestic level of savings increases (from 8 to 9.5) at the same time domestic investment decreases (from 8 to 2) therefore the increase in the domestic level of savings (1.5) must be lent overseas.
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The Increase in the Domestic level of Savings
There is a cost of increasing the domestic level of savings (which is given by the area under the domestic savings curve between 8 and 9.5).
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The Increase in the Domestic level of Savings
However there is also a benefit from the increased domestic savings as it is lent overseas and yields a return of 10% (the gain is the area under the horizontal world real interest rate curve between the 8 and 9.5)
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The Decrease in Domestic Investment
As domestic investment decreases (from 8 to 2) while domestic savings increases (from 8 to 9.5) it must be that some existing domestic savings are freed up from having to finance domestic investment and so can be lent overseas.
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The Decrease in Domestic Investment
6 units of domestic savings which were being used to finance domestic investment are now being lent overseas at 10%
The cost to the domestic economy due to the reduction in the 6 units of domestic investment is given by the area underneath the investment curve between 2 and 8.
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The Decrease in Domestic Investment
The gain from lending the freed up domestic savings overseas is given by the area under the horizontal world real interest rate curve between 2 and 8
Since the return earned from lending the domestic savings overseas is greater than the foregone returns as a result of the reduced domestic investment the economy gains.
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Gains from Inter-temporal trade: Metzler Diagram – A small economy and a higher world real rate of interest
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S
I
At rc; S = I; CA = 0
At r1 > rc: S > I; CA > 0 ↔ ∆NFA > 0
The total gain = ?
rc
r1
S1
I1
ΔNFA > 0
∆S
r
I0
-∆I
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Comparative Advantage
Assume Economy A is a large economy so when it’s opened it effects the world real rate of interest.
Let economy B be another large economy with its savings and investment functions given by
IB=12 –0.5r
SB = -13+2r
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Comparative Advantage
Prior to economy opening up the real rate of interest in economy B is 10%.
Recall that Economy A’s closed economy interest rate is 7%.
The cost of 1 unit of current consumption (C0) in Country A is 1.07 units of future consumption.
For economy B, the cost of one unit of current consumption (C0) is 1.1 units of future consumption.
Country A can produce one unit of current consumption more cheaply in terms of forgone future consumption that can country B. Country A has the comparative advantage in producing current consumption. Country B therefore has the comparative advantage in producing future consumption.
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Comparative Advantage
Considering A and B together
34-2.5r = -8.5 +2.5r
r=8.5%
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Economy A
At the world real rate of interest of 8.5%, rc A < r. Country A will run a Current Account surplus and a Financial Account deficit.
Economy A’s closed economy real rate of interest is 7%. If it attempts to increase future consumption by internal means (increasing domestic savings and investment) and produces one less unit of current consumption it would only gain 1.07 units of future consumption. However, if it increases its future consumption by external means (exporting current consumption) it receives 1.085 units of future consumption for every unit of current consumption forgone. It is therefore better off by 0.015 units of future consumption.
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Economy B
At the real rate of interest of 8.5%, rc > r. Country B will run a Current Account deficit and a Financial Account surplus.
Since Economy B’s closed economy real rate of interest is 10% if it attempts to increase current consumption by internal means (reducing domestic savings and investment) and produces one more unit of current consumption it would cost 1.1 units of future consumption. However, if it increases its current consumption by external means (ie importing current consumption) it only costs 1.085 units of future consumption for every unit of current consumption. It is therefore better off by 0.015 units of future consumption.
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Summary
If a country has a preference for current over future consumption and/or has abundant productive investment opportunities it is likely to have a high closed economy real rate of interest and thereby run a Current Account deficit and a Financial Account surplus.
A Financial Account surplus means that the country is issuing future claims on itself which is effectively the giving up of future consumption claims.
If a country has a preference for future over current consumption and/or there is an absence of productive investment opportunities it is likely to have a low closed economy real rate of interest and run a Current Account surplus and a Financial Account deficit.
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Summary cont
A Financial Account deficit means that the country is accumulating future claims on foreigners which results in an increase in future consumption claims.
Hence if two countries have different intertemporal consumption preferences and investment opportunities both can be made better off as a result of trading consumption claims over time.
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Global Imbalances in Practice
In the years from 1998-2008 the pattern of CA did not seem to conform with to what would be predicted by the intertemporal model
Theory predicts that developed economies will export current consumption goods to less developed economies in exchange for claims on future consumption (i.e. financial assets).
United States ran enormous current account deficits. China, the rest of East Asia, and the oil exporting countries ran correspondingly large current account surpluses
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What’s different about the US
Assumed that interest rate is the same for income paid and interest received
We assume no capital gains on external wealth
These don’t hold for the US :-
Receives a higher rate of interest on its assets (e.g. Treasury bonds) than it pays on its liabilities
US has enjoyed capital gains on its holdings of external assets and smaller capital losses on its external liabilities
How covid-19 could change the financial world order | The Economist
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Lucas Paradox
the Lucas paradox or the Lucas puzzle is the observation that capital does not flow from developed countries to developing countries despite the fact that developing countries have lower levels of capital per worker.
Lucas, Robert (1990). "Why doesn't Capital Flow from Rich to Poor Countries?", The American Economic Review 80 (2): 92–96.
Alfaro, Laura, Sebnem Kalemli-Ozcan and Vadym Volosovych (2003) “Why doesn’t Capital Flow from Rich to Poor Countries? An Empirical Investigation” University of Houston, December.
https://www.imf.org/external/pubs/ft/fandd/2007/03/prasad.htm
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Current Account and the Intertemporal model
The Intertemporal Model could be used to predict Crisis:
Before the Italian devaluation in the third quarter of 1992, Italy was running a current account deficit, which was higher than the one predicted by the Intertemporal model. After the crisis, the current account switches to surplus
Similar to Italy, during the same period, Sweden has been running a current account deficit before the crisis, when the model was a predicting a surplus.
Similar to the case of Sweden and Italy, Spain deficit was higher than the one predicted by the model before the crisis.
Korea and Philippines have been running deficits much higher than the ones predicted by the model and then similarly to Italy higher surpluses after the crisis.
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Source: Saksonovs, S. (2006). The intertemporal approach to the current account and currency crises. Cambridge University, Darwin College Research Report, DCCR-05.
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Current Account and the Intertemporal model Cont’
The Intertemporal Model is not a crystal magic ball in forecasting:
The model did not fit well for UK and Mexico
The failure to accurately predict could be attributed to several factors. The following may help to explain why the Model performed so bad for these countries.
Some of the crises can arise not due to the current account deficit that is not optimal, but rather due to adjustment to different equilibrium determined by changing fundamentals
Alternatively, could simply be due to the overall panic in the financial markets (contagion effect, EG the peso crisis and the Asian financial crisis.)
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Source: Saksonovs, S. (2006). The intertemporal approach to the current account and currency crises. Cambridge University, Darwin College Research Report, DCCR-05.
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Are Current Account Deficits Bad or Sustainable?
New Zealand’s Current Account has been persistently in deficit since the early 1970’s and increased significantly during the late 1990s.
The question is: Should this be a cause for significant concern?
A research by Kim, Hall, & Buckle (2001) could not reject the hypotheses that New Zealand’s current account was consistent with optimal smoothing
This is to say New Zealand has managed to satisfy the external solvency condition, and that there is “no excess volatility” in international financial capital flows.
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Kim, K., Hall, V. B., & Buckle, R. A. (2001). New Zealand’s current account deficit: Analysis based on the intertemporal optimisation approach. New Zealand Treasury.
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NZ current account now!
New Zealand’s current account surplus widened to NZD 1.56 billion in the first quarter of 2020 from NZD 0.72 billion in the corresponding period of the previous year and compared with market expectations of a NZD 1.48 billion surplus.
It was the largest current account surplus since the third quarter of 2016, as the goods surplus increased to NZD 0.97 billion from NZD 0.21 billion a year ago. Also, the primary income gap decreased to NZD 2.21 billion from NZD 2.38 billion.
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Topic 2
Supplementary slides
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INTER-TEMPORAL MODEL: An Application of Comparative Advantage
Some countries will have a comparative advantage in future production of consumption goods.
A low relative price of future consumption, or a high real interest rate - Rc.
Their PPF is biased toward production of future goods
Others will have a comparative advantage in current production.
A low relative price of current consumption, or a low real interest rate - Rc.
Their PPF is biased toward production of current goods
It may be optimal for these countries to trade consumptions over time. The Home Country runs a current account deficit and accumulates external debt; vise versa the Foreign Country. Both gain!
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CA < 0
∆NFA<0
CA > 0
∆NFA > 0
Future
goods
Current goods
FOREIGN (low r)
Future
goods
Current goods
HOME (high r)
H
F
A
B
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You tube videos of interest
Ray Dahlio Ray Dalio on the Economy, Pandemic, China's Rise: Full Interview
https://www.youtube.com/watch?v=7WxfQ2zKXeA
How the Economy works – Ray Dahlio – 2013 – Consider these fundamental in todays post Covid economy
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Definitions
Absolute advantage: a country can produce a good relatively more efficiently than another country (example: Japan better at cars than Australia)
Alternatively, a country is said to have an absolute advantage if it can produce more goods and services with the same resources than the other.
it is possible for a country to have a comparative advantage in all goods and services
Comparative advantage: a country can produce a good relatively more efficiently than another good in comparison with another country.
Alternatively, a country that produces a good or a service at a lower opportunity cost is said to have a comparative advantage in the production of that good or a service.
It is the principle of comparative advantage that makes trade beneficial and not possible for one country to have a comparative advantage in everything.
Principle of comparative advantage implies that each nation should specialize in production of those goods for which it is relatively more efficient with a lower opportunity cost
Applies to people as well as to countries
https://www.youtube.com/watch?v=Pd_qs8ueIWw
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