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Topic 1 The inter-temporal approach to the current account (applications)

A two country world


In the simple 2 period model, we assumed that the real interest rate was exogenous the island economy was small. Once we allow for a world comprising two large blocs (US and China), the real interest rate can be determined endogenously.

Fisher separation no longer holds. Shifting consumption preferences can change the interest rate and, in turn, investment.

The optimisation problem for each country is

And the Euler equation is

Next, specify production functions, utility functions and the intertemporal budget constraint for each country

Note that the world as a whole is a closed economy, ie CAt + CA*t = 0. And the higher is the intertemporal elasticity of substitution, the more willing we are to give up present consumption in exchange for future consumption if conditions change. See O&R for the solution of C1

Changing the interest rate has complex effects on consumption (savings) behavior
Substitution effect Income effect Wealth effect

In a nutshell, if r increases it is good news for lenders and bad news for borrowers income effect Substitution effect implies we reallocate resources to the good that is relatively cheap. A rise in r changes the discounting of period 2 output (Y2/1+r) lowering lifetime wealth

Finding the world interest rate

Productivity shock in advanced country

Savings glut?
Bernanke suggests that global imbalances in current accounts are driven by events largely outside US.
Strong savings motives of rich countries with ageing populations Asian countries becoming net exporters of capital post 1997, precautionary building of reserves Sharp rises in oil prices leading to CA surpluses in oil exporters in Middle East, Russia

Model implies real interest rates will be low if desired saving > desired investment

Some puzzles
Puzzle 1: Why does capital flow in the wrong direction? Emerging market economies are lending to the advanced countries.

Bernanke difficult investment climates in the EMEs and a lack of financial liberalization. We will visit this issue in the next couple of lectures

Puzzle 2: Is capital less mobile than we presume (FeldsteinHorioka)?

The basic model assumes capital is perfectly mobile and a countrys saving will seek out the most productive investment worldwide. So savings and investment will diverge over time

Some countries (especially EMEs and Australia pre 1983) tried to target the CA. If firms face credit constraints and cannot borrow freely, then their investment will depend on their retained earnings (i.e. their savings).

Plenty of unresolved puzzles in international macroeconomics!!