International

Economics
1. Intertemporal Trade and the Current Account Balance 2 1.1. Small Two-Priced Endowment Economy ..................... 2 1.1.1. The Consumer Problem ................................................. 2 1.1.2. Equilibrium of the Small Open Economy ............... 7 1.1.3. International Borrowing and Lending, the Current Account, and the Gains from Trade ......................................... 7 1.1.4. Autarky Interest Rates and the Intertemporal Trade Pattern .............................................................................................. 10 1.1.5. Temporary versus Permanent Output Changes10 1.1.6. Current account with Government consumption11 1.1.7. A Digression on Intertemporal Preferences ...... 11 1.2. The Role of Investment ...................................................... 11 1.2.1. Adding Investment to the Model ............................ 12 1.2.2. Budget Constraint and Individual Maximization13 1.2.3. Production Possibilities and Equilibrium ........... 17 1.2.4. The Model with Government Consumption ...... 17 1.3. A Two-Region World Economy ...................................... 17 1.3.1. A Global Endowment Economy ............................... 17

1. Inter-temporal Trade and the Current Account Balance

1.1. Small Two-Priced Endowment Economy

1.1.1.
Hypothesis:

The Consumer Problem

Basic model with two periods, t= 1,2 1 good world (fully tradable) Open economy with a representative household (agent) Small open economy (no market power, i.e. takes international prices as gives, interest rate in this case) 1 asset (homogenous 1 period bond) Representative Agent maximizes: U(C1,C2) s.t. the two budget constraints faced by the agent (budget of period 1 and 2) 1) C1 + A2 = y1 yt: output in t A2 = NFA at the end of t = 1 Ct: consumption in t

(Savings = net foreign position of the country at the end of 2) C2 = y2 + A2 * (1+r) r: interest rate

period 1, can also be negative)

 Assume Current account in this setup is A2 (if you have 2 periods only, i.e. no wealth inherited form the past A1) A2 = CA1 Max U(C1) + *U(C2) U>0, U<0 (strictly concave)
!

U(C1, C2) = U(C1) + *U(C2)

U(C1) = period utility

0 < < 1 and is the subjective discount

factor

0 < < 1
!!!

s.t. (1) C1 + A2 = y1

(2) C2 = y2 + A2 * (1+r) NB: : Two cases: C1 = 2 C2 = 1 C1 = 1 C2 = 2

If is small people will prefer the first option where you get more today than later (C1 = 2 & C2 = 1). High means higher patience. is a psychological discount factor applied to utility of future consumption. is the subjective discount rate.

Solving the maximization problem: From (1) A2 = y1 - C1 Into (2): C2 = y2 + (y1 - C1) * (1+r) !! + With
! !!! !! !!! !! !!!

= !! +

price in t=1 (in units of output at t=1) of 1 unit of output

in t = 2 Gives us a new optimization problem with only one constraint: Max U(C1) + *U(C2) s.t. Max U(C1) + *U[C1 * (1+r) + C2 - C1* (1+r)] C1: U(C1) + *U[C1 * (1+r) + C1 - C1* (1+r)] = 0 U(C1) = (1+r) * * U(C2)
1 + ! ! !
! ! !! !!

!! +

!! !!!

= !! +

!! !!!

C2 = C1 * (1+r) + C2 - C1* (1+r)

= 1

This is the Intertemporal Euler

Equation This equation is the key of dynamic economics!

NB: Intuition that underlines the Euler equation Assume U(C1) > (1+r) * * U(C2) If this inequality holds welfare benefits exceeds welfare costs by consuming in C1. As long as it holds, its easy for the agent to increase welfare (lifetime utility) by increasing C1 and cutting C2. This means the agent will increase C1. If U(C1) < (1+r) * * U(C2)

Euler assumptions explained by a graph:

C is the optimal choice, i.e. C1 and C2 are such as U(C1) = (1+r) * * U(C2)

With

! !!!

, Assume (1+r)* = 1

This means r = If (1+r)* = 1: U(C1) = U(C2) C1 = C2 That means the agent/country wants to stable out consumption over the two periods. This is called consumption smoothing. This way the consumption of a country can be much smoother than the income by lending or borrowing.
If r > :

U(C1) > U(C2) C1 < C2 because the utility

function is strictly concave. Thus, even if the r = relation doesnt hold we still have a much more constant consumption than output, i.e. consumption tends to be much more similar over the two periods than output. If the interest rate r is a little bit higher than the subjective discount rate , consumption at t=1 will only be slightly lower than in t=2. r = : C1 = C2 = C Lets put this into the budget constraint: ! !! = !! + 1+! 1+! 1 !! + 1 + ! !! !! = !! = ! = 1 1+1+! !+ != 1 + ! !! + !! 2+!

1.1.2.

Equilibrium of the Small Open Economy

This section only gives some further explanations

1.1.3.

International Borrowing and Lending, the

Current Account, and the Gains from Trade

1.1.3.1. Defining the Current Account International trade across countries is recorded in the Balance of Payments (BoP) captures borrowing and lending between countries. A country is the aggregate of the residents of that country (aggregate perspective) that have external assets and liabilities towards foreign countries and their residents. External assets = lending to the foreigners External liabilities = we borrow outside. Foreigners hold shares and bonds. Difference between the external assets and liabilities (A L) is called Net foreign Assets (NFA), written Bt. If it is positive, claims are larger than what the country owes to the rest of the world (Germany, Japan, China). Assets and liabilities are a stock variable, observed at a certain time. This leads to the notion of Current Account (CA). The current account is a variable measured over a given period. It measures the change of the NFA over a certain period.

 CAt = S I = Bt+1 Bt = Yt + rtBt Ct Low saving and high investments gives you a negative current account. If CA is negative over several periods the NFA will probably be negative. NB: Financial crisis: capital flowed into the US boom in the housing sector highly indebt banks etc. massive current account deficit 1.1.3.2. GNP and GDP This section is about the difference between GNP and GDP. Not important for us? 1.1.3.3. The Current Account and the Budget Constraint in the Two-period Model Using the old constraints: (1) C1 + A2 = y1 We know that: CA1 = A2 = y1 C1 Where y1 C1 is the trade balance = net exports Thus we get: !"! = !!
!! !
! ! !! ! ! ! !! !! !

&

(2) C2 = y2 + A2 * (1+r) using (1)

 And by rearranging we get: This means that:

!"! !! !! = 2+!

CA1 > 0 y1 > y2 CA1 = 0 y1 = y2 CA1 < 0 y1 < y2 Thus, if a country wants to smooth out consumption, it has to shift some of it resources from t=1 to t=2. If r = 0, current account will be the average of both outputs.

Consumption smoothing assumes that a country will lend to the rest of the world if current output is larger than future output.

1.1.4.

Autarky Interest Rates and the Intertemporal

Trade Pattern
Didnt cover this part in the lectures?

1.1.5.

Temporary versus Permanent Output Changes

Case of a one-time shock on outputs If y1 increases, CA1 increases. If output in period 1 increases the country gets wealthier. It therefor consumes more in period 1 and 2 (because of the consumption smoothing logic). But in order to increase C2 we have to save more in period 1 and thus lend to the rest of the world. The result is an increase of CA1. Similarly, if we anticipate that y2 will increase (discovery of raw material) and the agent/country feels wealthier. The result is that the agent wants to consume more in 1 and 2 (because she wants to smooth out consumption). Finally the CA1 decreases because the country will borrow form the rest of the world. Case of a permanent shock to output y1 = y2 > 0 CA1 = 0 This means that permanent shocks dont have any effect on the current account. Why? The reason again is consumption smoothing, because it can be achieved without needing funding

from the rest of the world, but we just consume the additional output received in 1 and 2.

1.1.6.

Current

account

with

Government

consumption
What we have seen until now was the first model of current account. We will now include: Government Physical investment (changing capital stock an thus output) Gt: government consumption The government is not productive. But it can take output (levy taxes) from the agent to fund its consumption. Gt is financed using tax revenues Tt. G1 = T1 + D2 where D2 is public debt at the end of t=1 G2 + D2*(1+r) = T2

1.1.7.
??? 1.2.

A Digression on Intertemporal Preferences

The Role of Investment

Investments = Savings (I = S) in a closed economy NB: Physical investments =/= financial investment

1.2.1.

Adding Investment to the Model

Consumers have to lower consumption to be able to save and this way able to invest. Facts observed in praxis: Net exports and current account are countercyclical, i.e. negatively correlated with output (GDP) Investment is pro-cyclical, i.e. positively correlated with output. Using our model, if output goes up today (boom) I will save more (C1 doesnt improve the same way than Y1 consumption smoothing), and CA balance will improve. However, this is not what actually happens, i.e. something is missing. When conditions improve today, conditions tomorrow will be good too but a bit less (mean reversion). (?) NX (goes up) = Y (goes up) C (goes up less) I (increases a lot) Physical investment in the CA: Yt = t * F(Kt) with Kt = optimal stock in t t is a parameter K2 = K1 + I1

1.2.2.

Budget Constraint and Individual Maximization

Investment competes with consumption as a use of resources. The budget constraint consequently is: !! + !! + This is a two-period economy. It does not make sense for a household to have a positive capital stock at the end of period two, because there is no period 3 (optimal K3 = 0 optimal I2 = -K2). Consumption can be transformed 1 to 1 into investment and investment can be negative. (Example: agriculture: I = grain put in storage, output and K (capital) can be eaten, stored or sold. At the end of the farmers life he will use up all the stock.) The budget constraint in function of the capital stock is: !! + !! !! + 1 !! + !! 1+! 1 = ! ! !! + ! ! (!! ) 1+! 1 1 !! + !! = !! ! 1+! 1+! !

The objective is still to maximise total welfare: Max U(C1) + *U(C2) in regards to C1, C2 & K2. (This time using a Lagrange, i.e. L = U(C1) + *U(C2)) We take the derivative

! {!! + !! !! + ! !! ]}

1 1 !! + !! [! ! !! + ! 1+! 1+!

! = ! ! !! + ! = 0 ! !! ! ! = ! ! !! + = 0 ! !! 1+! ! 1 1 =! 1 ! ! ! !! ! !! 1+! 1+! 1 1 1 = ! ! ! !! 1+! 1+!

! = ! ! ! !!

= 0

Euler Equation for Capital

which is the marginal product of capital at t=2 NB: Intuition that underlines the Euler equation for capital Assume r > 2*F(K2) We would rather invest in bonds because return r is higher than return on capital. if r < 2*F(K2) In this case the agent will invest in capital because return on capital is higher than return on financial products r. Therefore: ! = ! ! ! (!! ) Both returns have to be (and will be) equal because otherwise the agent would switch to the higher yielding one

 Each unit that the agent puts into capital in period 1 raises the resources in period 2 by 1 + ! ! ! !! . Thus, 1 + ! ! ! !! = 1 + ! Decision rule: The agent will invest into capital as long as its return is higher than r. The capital stock does not depend on consumption, on preferences or on the patience of the country. The optimal choice of K2 thus equalizes this equation.
! = ! ! ! !! !! ! ! !! ! ! !!

Euler still holds: 1 + !

= 1

Now assume: (1+r)=1 C1=C2 (perfect consumption smoothing) NX1 = Y1 - I1 - C1 = CA1 it is equal to CA because Y1 = C1 + I1 + A2 and A2 = CA1 !"! = Possible scenarios: 1. if 1 increases Y1 increases, I1 doesnt change, CA1 increases 2. if 2 increases (anticipated in t=1 i.e. a news shock) Y1 doesnt change, I1 increases (graph), I2 decreases i.e. becomes more negative (graph), CA2 drops. We expect higher (!! !! ) (!! !! ) 2+!

productivity in 2, thus we consume less today and invest more and consume the additional capital stock in 2.

Optimal K2 3. Permanent increase in Assume: 1 = 2 (shock is the same for both periods) Assume: K1 = K2 and Y1 = Y2 before the shock !! = ! ! !! !! = ! ! !! Because both increase (and K2 because of 2) both outputs rise. (Attention: no derivatives in these equations) !"! = (!! !! ) (!! !! ) (!! !! ) !! + !! = 2+! 2+!

Y2 increases more than Y1 and I1 increases, I2 decreases the CA1 decreases. In other words, permanent increase in CA1 decreases. CA is countercyclical Did not cover: (?)

1.2.3. 1.2.4.
1.3.

Production Possibilities and Equilibrium The Model with Government Consumption

A Two-Region World Economy

1.3.1.
??

A Global Endowment Economy