Understanding Current Account Dynamics in Balance of Payments

1. CURRENT ACCOUNT DYNAMICS I. Balance of Payments (Flows , not stocks) (1) Current Account ( exports / imports of goods and services). Balance: (2) Capital Account ( exports / imports of securities and financial assets) balance: capital imports or exports exports of securities = ( financial ) capital imports import of securities = ( financial ) capital exports (3) International Reserves Account:

2. Current Account and National Income Account C = consumption Q = Gross Domestic Product G = government consumption I = investment B = External Debt Y = Gross National Product

3. GNP domestic absorption current account balance T= tax revenue National Saving

4. Consumption Smoothing Budget constraints (period by period): Consumption - possibilities constraint: Permanent Income

5. Consumption smoothing  consumption in period 2 W c q 1+r W consumption in period 1 S = CAB

6. 1. Temporary productivity shock consumption in period 2 c’ c q q’ 1+r consumption in period 1

7. 2. Permanent Productivity Shock consumption in period 2 c’ c q’ q 1+r consumption in period 1

8. A Permanent Productivity Shock consumption in period 2 MPC = 1 1+r consumption in period 1

9. 3. Personal Savings are the market-forecast of future decline in GDP (assume : r = 0) assume : r  0

10. Diagram Useful to Analyze Dynamics of the Current Account Balance S r CAB r* I I,S 1. r* S, I 2. Temporary productivity increase 3. Permanent productivity increase 4. Budget deficit through (1) tax reduction (2) rise in G 5. A stock market crash by 10%

11. Consumers There is not taxes on interest rate payments Government

12. (1) Emerging markets current account deficits driven by excessive investments (2) Reversal of current account deficits achieved through (1) Real depreciation (2) Output contraction (3) Japan’s current account surplus  high saving rates (4) Sustainability of current account deficit depend on debt, equity and FDI finance

13. Resource Constraint Permanent income = Current Account Balance

14. For every variable X define its corresponding “permanent” variable

15. Intertemporal Budget Constraint and Consumption-Smoothing Current Account Balance (1) Definition “permanent” X (2) Deviations from “permanent” (3)

16. Consumption Smoothing  current account deficits reflect expected increases in future net output