Lectures 16 and 17

1. Lectures 16 and 17 Intertemporal approach to current account determination

2. NOAA/Satellite and Information Service Hurricanes • Hurricanes are an example of a severe negative shock to economic output. • In the years immediately following a hurricane, the increase in investment associated with rebuilding can be financed through the current account, so that consumption need not fall as much.

3. Hurricanes • Saving declines, but a country can still borrow from abroad to finance investment. • Average responses in Central America & Caribbean countries, excluding unilateral transfers (e.g., aid)

4. Intertemporal Macroeconomics • Intertemporal Approach • Useful to start with an analogy for an individual household. Consider two cases: • Case 1: A debt that is serviced. Household makes interest payments on debt, but never pays down the principal amount borrowed. At the end of each period, the lender renews the loan (a rollover). • Case 2: A debt that is not serviced. Household pays neither interest owed nor the principal. In this case, the amount owed will grow over time.

5. Intertemporal Macroeconomics • Case 2 is not sustainable because all debts must be paid off eventually. • Case 2 is also known as a Ponzi scheme. • We will rule it out.

6. The Long Run Budget Constraint • Assumptions for a simple model: • Prices are perfectly flexible. All quantities are real. • The country is a small open economy. • All debts carry a fixed real interest rate r*, the world real interest rate. • Net interest income = r*W • Country pays r* on start-of-period liabilities, L and receives interest r* on start-of-period assets, A. • Net interest income received is therefore r*(A–L) = r*W, where W is external wealth.

7. The Long Run Budget Constraint • Assumptions for a simple model: • No unilateral transfers (NUT = 0), no capital gains earned on external wealth, no capital account, no other factor income from abroad.

8. The Long Run Budget Constraint • Calculating Change in Wealth Each Period • As we learnt earlier, the change in external wealth is here equal to the current account. • Consider change in wealth in a given period, N:

9. The Long Run Budget Constraint • Calculating Future Wealth Levels • Subtracting WN–1 from both sides yields the following expression for external wealth in period N:

10. The Long Run Budget Constraint • The Two Period Case • Suppose there are two periods in the economy. The current period denoted 0 (= N) and the previous period is denoted -1 (= N-1): • The next period is denoted 1 (= N + 1): • Substituting in expression for current wealth,

11. The Long Run Budget Constraint • The Two Period Case • Country’s wealth at end of period 1 depends on • Initial external wealth plus interest accrued. • Trade balance each period prior plus interest accrued. • Assume debts must be repaid, so country has no external wealth in the last period (period 1 in this case), W1 = 0.

12. The Long Run Budget Constraint • Present Value Form of the LRBC • Dividing both sides by (1 + r*): • Any payment at any time in the past, present of future can be expressed in present value terms. • Compute what payments are worth in today’s dollars by adjusting for compound interest. • Payment of X in year N equivalent to X/(1+r*)N in year 0.

13. The Long Run Budget Constraint Example • W-1 is –$100 and r* is 10%. • What present value of the trade balances satisfies the LRBC? • Many ways this could be achieved. • Two-Period LRBC Example • W-1 > 0: net creditor => run future trade deficits • W-1 < 0: net debtor => run future trade surpluses

14. The Long Run Budget Constraint • The Long Run Case • Extend to general case with several periods. • An initial credit/debt must be balanced by offsetting trade surpluses or deficits in the future (in present value terms). • The stream/sum of trade balances is what matters. The LRBC does not require that a debtor country run a trade surplus each and every year, only cumulatively.

15. Example: The Perpetual Loan • Country pays a fixed amount X each period beginning in period 1. • This expression simplifies to: • E.g., you owe a perpetual $2000 at 5% interest, so you must pay the lender X=$100 interest forever. • PV(X) = 100/0.05 = 2000. You never pay off the principal.

16. Implications of LRBC for GNE and GDP • GDP = C + I + G + TB • TB = GDP – GNE. • Now plug this into the LRBC:

17. Implications of LRBC for GNE and GDP • Implications: • LRBC says, in the long run, in present value terms, a country’s expenditures (GNE) must equal its production (GDP) plus any initial wealth. • Shows how the country is able to finance differences between its production and spending through borrowing/lending over time.

18. The Favorable Situation of the United States • “Exorbitant Privilege” • U.S. a net debtor, W < 0, since 1980s, yet factor income from abroad has been positive. • Can a net debtor earn positive interest income? • Yes. U.S. pays a low rate of interest on external liabilities relative to rate of interest on external assets, r* – r0. • Roughly 1.5–2 percentage points difference.

19. The Favorable Situation of the United States • “Manna from Heaven” • U.S. also had capital gains on external wealth. • Rate of capital gains also higher on external assets than on external liabilities. • Another roughly 2 percentage point difference.

20. The Favorable Situation of the US • Where are these gains coming from? • The BEA data indicate neither price, nor exchange rate effects. Just “other” gains? • Remains a mystery and the subject of ongoing research. • LRBC • Modify LRBC to account for these two features (differences in interest rates and capital gains). • The two additional effects in the expression above show how the U.S. is able to offset the negative effects of trade deficits on external wealth.

21. The Favorable Situation of the US • Too Good to Be True? • Adjustments are big • Worth an extra 2.8% of GDP gain each year recently. • But some argue that the official BEA data may be wrong • Incomplete accounting of income paid to, and assets owned, by foreigners. • U.S. external wealth position may be far worse than we think.

22. The Difficult Situation of the Emerging Markets • Assumptions revisited • No risk premium: same interest rate paid on assets and liabilities. • No debt limit: countries are able to borrow and lend freely, as long as they satisfy the LRBC. • Risk premiums and debt limits are a reality

23. The Difficult Situation of the Emerging Markets • Risk Premiums • Investors require a risk premium in order to be willing to buy your assets. • Creditworthiness measured by credit rating, and this is correlated with interest rate charged (e.g. junk bonds). • As a country’s debt increases, this increases risk of default, so the bond rating typically declines. • Advanced countries barely affected by this problem.

24. The Difficult Situation of the Emerging Markets • Debt limits—nobody willing to buy your assets • Lead to sudden stops in the flow of external finance. • financial account surplus rapidly shrinks, • requiring a decrease in current account deficit, • requiring a sudden cut in expenditures (GNE) relative to production (GDP).

25. The Basic Model • More simplifying assumptions • Value added GDP = Q, is produced using only a labor input. Q is subject to shocks. • Consumption (C) by identical households (i.e. countries). C must satisfy LRBC. • No other sources of demand for goods and services. I = G = 0. C = GNE and TB = Q – C. • Country begins with no external wealth, W-1 = 0. • Open economy trades with rest of the world (ROW). • Key assumption about objectives • Consumers desire smooth consumption.

26. Consumption Smoothing: Example • LRBC 0 = Present value of TB Present value of Q = Present value of C • Examine two cases: • Closed economy: TB = 0 LRBC satisfied automatically with PV(TB)=0 • Open economy: TB ≠ 0Must verify that LRBC is satisfied; PV(TB)=0. • Benchmark numerical values: • r = 5% and Q = 100

27. Consumption Smoothing: Example • Closed versus Open, No Shocks • Closed economy • Q = 100 = C in each period; TB=0 • PV(Q) = 100 + 100/0.05 = 2100 = PV(C) • Open economy • Q = 100 = C in each period; TB=0 • PV(Q) = 100 + 100/0.05 = 2100 = PV(C)

28. Consumption Smoothing: Example • Closed versus Open, No Shocks. • In an open economy with no shocks, there is no reason to borrow or lend. • The household is able to maintain smooth consumption every period. • No gains from being open.

29. Consumption Smoothing: Example • Closed versus Open, Shocks. • Temporary, negative shock to output (of –21 units) in year 0, so output is 79. Output is equal to 100 units in every period thereafter. • What happens? • In the closed economy, the household is unable to smooth consumption.

30. Consumption Smoothing: Computation • How can the open economy do better? • Use the LRBC: • Figure out change in resources (fall in PV of GDP) • Figure out required change in consumption (fall in PV of C) • Compute the present value of GDP: • Since Q0 = 79 and output is equal to 100 thereafter:

31. Consumption Smoothing: Computation • Compute C each period • Consumption smoothing (C0 = C1 = C2 =…. = C): • From above, we know PV(Q) = 2079 = PV(C): • Therefore, C = 99 in every period if it is smooth • Hint: PV(Q) has fallen by 1%, from 2100 to 2079, so C must fall by 1% in all periods to still be smooth and satisfy LRBC.

32. Consumption Smoothing: Computation • Now have full solution for the open economy • Compute TB each period • Q0 = 79 and C0 = 99, TB0 = –20 (= Q0 – C0). • In subsequent years is TB = +1 (= 100 – 99 = Q – C). • Compute external wealth W and NFIA each period. • After period 0, external wealth is +20, amount borrowed. • Then the country services this debt, paying 1 unit in interest (=20 × 0.05), so NFIA = –1 in year 1 and thereafter. • Compute CA each period. • Current account is the sum of trade balance, net factor income, plus net unilateral transfers (assumed to be zero) • CA0 = TB0 = –20 in the first period. • CA = 0 thereafter, since TB = +1 and NFIA = –1.

33. Consumption Smoothing: Computation • Closed versus Open, Shocks. • In the open economy, the present value of output is the same, yet the household is able to smooth consumption through running a trade deficit in period when the negative shock reduces output.

34. Consumption Smoothing: Generalizing • Generalizing • When a country experiences a shock, output will change, but consumption will change by a smaller amount as the country borrows/lends the difference between Q and C:Left-hand side is the amount paid/received in interest on the amount borrowed/lent. • Solving for the change in consumption:

35. Consumption Smoothing: Permanent Shocks • Permanent Shocks? • If a country faces a permanent shock to output, then it will be forced to FULLY adjust its consumption, regardless of whether it is a closed or open economy. • Trade balance cannot be used to make up the difference between consumption and output because the change is permanent—remember we assumed no Ponzi games. • An important result from the model: consumers can smooth out temporary shocks, but they must adjust to permanent shocks.

36. Summary: Consumption Smoothing • “Save for a rainy day” • The model shows how a country can lend or borrow when it experiences shocks to output, allowing the country to smooth consumption. • Positive shocks—save • Country has a trade surplus and external wealth rises. • Negative shocks—borrow • Country has a trade deficit and external wealth falls.

37. Wars and the Current Account • Consider the effects of wars in the model. • Incorporate G into the model, GNE = C + G • Government spending is simply more consumption. • During war, G increases, increasing GNE. • Wars as “emergency spending” • For a given level of output, does consumption need to decrease during a war? No. • As long as wars are temporary, the government can pay for this added expenditure by external borrowing (deficits), and then hope to pay back later (surpluses).

38. Wars and the Current Account • Financial development in 1700s allowed Britain to borrow domestically and externally. • Important role of Dutch creditors, e.g. Napoleonic Wars. • A key component in military supremacy over continental rivals. • Recently, U.S. wars in Afghanistan and Iraq coincided with large CA deficits.

39. Consumption Volatility and Financial Openness • Implication: greater financial openness should reduce consumption volatility. • We can look at the ratio of volatility of consumption relative to volatility of output. • According to the model, this ratio should be less than one in a small open economy • Would be zero if no shocks were global—but some shocks hit all countries and can’t be smoothed.

40. Consumption Volatility and Financial Openness • Data • Ratio far from zero, even for open countries. • In many cases, the ratio is greater than one.

41. Consumption Volatility and Financial Openness • Why don’t the data match the model? • Financial globalization might not reach consumers in poorer countries. • Financial markets in emerging markets and developing countries may not be fully developed, or may be limited in their access. • It may be the case that borrowing and lending alone may not be a completely effective way to smooth consumption.

42. Precautionary Saving, Reserves, and Sovereign Wealth Funds • How can poor countries better smooth their consumption? Precautionary saving. • Government saving in a “rainy day” fund in case of a sudden stop. Keeps high level of external wealth which for use as a buffer against shocks. (equity and FDI.)

43. Precautionary Saving, Reserves, and Sovereign Wealth Funds • Two common forms of precautionary saving: • Foreign reserves: usually safe assets, e.g. U.S. Treasuries, owned by central bank. • Sovereign wealth funds: state-owned companies that invest in safe assets (foreign reserves) and riskier high-return assets (equity and FDI.)

44. Copper-Bottomed Insurance • Background on Chile’s SWF • In 1990, Norway created a stabilization fund to offset shocks associated with its oil exports. • Chile’s government uses profits on its state-owned copper company and taxes collected from private-owned mines for a “economic and social stabilization fund”—a sovereign wealth fund. • Economy Minister Andrés Velasco describes the objective as to “spend that which is permanent and save that which is transitory”.

45. Copper-Bottomed Insurance • Key Statistics • $6 billion in the fund and expects to add another $6 billion by end of 2007 (10% of Chile’s GDP). • In 2007, price of copper tripled to $3 per pound. • Chile per capita income $7,100 (1/7 of Norway).

46. Copper-Bottomed Insurance • Lessons • Commodity exports can have very volatile prices. • Large GDP and GNI fluctuations for producers. • SWFs insulate consumption from this volatility.

47. The Next Globalization Backlash? • Will SWFs lead to trouble? • Governments increasingly seeking private investment opportunities—historically relied on U.S. Treasury bills and risk-free bonds. • When governments purchase large shares of U.S. companies with access to sensitive information, this raises concerns about national security. • Potential for political conflict increases. • Example: When Chinese purchase of $3 billion in shares in Blackstone Group, a private equity firm that owns U.S. businesses with sensitive national-security information.

48. The Next Globalization Backlash? • Top SWFs getting larger • Oct 2007 data from IMF report: Over $100bn $25–$100 bn Abu Dhabi $250–875 bn(?) Australia $42 bn Norway $308 bn US-Alaska $35 bn Saudi Arabia $250+ bn Brunei $30 bn Kuwait $160–250 bn Singapore $200+ bn China $200 bn Russia $127 bn

49. The Basic Model • Output is produced using both labor input and capital input, and the latter requires investment. • GNE = C + I. • The LRBC becomes: PV(Q) = PV(C) + PV(I)

50. The Basic Model • As before, examine two cases: • Closed economy: • TB = 0 in all periods, • LRBC is automatically satisfied. • Open economy: TB ≠ 0. • Trade balance can be used to finance differences between GNE (C + I) and GDP (Q). • As before, we need to verify the LRBC holds.