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					Lectures 16 and 17

Intertemporal approach to
current account determination
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      NOAA/Satellite and Information Service


  the current account, so
  that consumption need
  not fall as much.
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)
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.
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.
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.
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.
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:
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:
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,
The Long Run Budget Constraint
   The Two Period Case

              wealth at end of period 1
     Country’s
     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.
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.
The Long Run Budget Constraint
   Two-Period LRBC Example




     W-1 > 0: net creditor => run future trade
      deficits
     W-1 < 0: net debtor => run future trade
      surpluses
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.
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.
Example: The Perpetual Loan
  Countrypays 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.
Implications of LRBC for GNE and GDP
   GDP  = C + I + G + TB
   TB = GDP – (C + I + G) = GDP - GNE.
   Now plug this into the LRBC:
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.
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.
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.
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.
    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.
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
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.
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).
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.
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 ≠ 0
      Must verify that LRBC is satisfied; PV(TB)=0.
   Benchmark numerical values:
    r   = 5%           and         Q = 100
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)
Consumption Smoothing:
Example
   Closed versus Open, No Shocks.
     Inan 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.
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.
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:
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.
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.
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.
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:
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.
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.
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).
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.
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.
Consumption Volatility and Financial Openness

     Data
       Ratiofar from zero, even for open countries.
       In many cases, the ratio is greater than one.
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.
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.)
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.)
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‖.
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).
Copper-Bottomed Insurance
   Lessons
     Commodity   exports can have very volatile
      prices.
     Large GDP and GNI fluctuations for
      producers.
     SWFs insulate consumption from this
      volatility.
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.
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
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)
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.
Efficient Investment: Example
   Consider the previous case, with shocks.
     Benchmark   case Q=100 in all years.
   Instead of a shock to output, we consider
    a new investment opportunity in year 0.
     Assume   the investment opportunity requires
      16 units of output today and will increase
      output by 5 units in every subsequent period.
     Before the shock, PV(Q) = 2100 and I = 0.
     Now, consider what happens when the
      investment opportunity arises.
Efficient Investment:
Computation
   Steps to computing numerical values.
     Identifyhow much output is needed to finance
      the investment project.
        I0   = 16, and is equal to 0 thereafter.
Efficient Investment:
Computation
   Steps to computing numerical values.
     Compute   C each period, assuming
      consumption smoothing and allowing for cost
      of investment.
          From above and LRBC, we know
Efficient Investment:
Computation
      Therefore, we know PV(C) = 2184 (=2200 – 16),
       since PV(Q) = 2200 and PV(I)=16.



      PV(C) is up 4% from 2100 to 2184. Thus C can
       rise by 4%.
Efficient Investment:
Computation
   Steps to computing numerical values.
     Compute    the trade balance in each period.
        Q0 = 100, I0 = 16, and C0 = 104, so
         TB0 = –20 (= Q0 – C0 – I0).
        The trade balance in the subsequent years is
         TB = +1 (= 105 – 104 = Q – C – I).
Efficient Investment:
Computation
  Compute      external wealth and NFIA each
   period.
     External wealth = –20, the initial amount borrowed.
     Each period, the country services this debt, paying
      1 unit in interest = NFIA = –1 (=20 × 0.05), as
      before.
  Compute      CA each period.
       CA0 = –20, and CA = 0 thereafter, as TB = –NFIA.
Efficient Investment: Example
   Open economy can borrow to finance
    investment, without having to reduce
    consumption today.
Efficient Investment:
Generalizing
   Generalizing
     Objective   is to maximize PV(C).
        This is PV(Q) minus PV(I).
        Invest if changes in PV(Q) exceeds change in
         PV(I).
Efficient Investment:
Generalizing
      Change in the present value of output is gain in
       future years from investment in year 0:




      The change in the present value of investment is
       the amount spent on the project in year 0:
Efficient Investment:
Generalizing
   Generalizing
     Bottom   line
        Undertake any project if MPK exceeds r*.
        Because this will increase PV(C) = PV(Q) – PV(I).
Summary: Efficient Investment
   Make Hay While the Sun Shines
     Open   economy
       Country able to separate consumption and
        investment decisions. Borrow/save through the
        world capital market.
       Efficient level of investment where MPK = r*

     Closed   economy
       Country must be self-sufficient and is unable to
        borrow from the world capital market.
       Will choose a lower level of investment versus
        open economy, because it finances projects with
        consumption.
Delinking Saving from Investment: Norway
    Background
      1960s:   Oil reserve
       discovered in North Sea
       in, but very costly to
       extract (MPK < r*).
      1970s: World price of oil
       increases.
      Permanent increase in
       the price of oil that then
       made the extraction of
       North Sea oil profitable
       (MPK > r*).
Delinking Saving from Investment: Norway
     Norway financed the large capital projects
      via the current account. Saving actually
      fell.
Gains from Diversification: Example
   Home Portfolios
     GDP   = GNI for each country.
     Each country owns 100% of home capital and
      labor.
Gains from Diversification: Example
   World Portfolios
     Each  country owns 50% of other country’s
      capital.
     Each country owns 100% of home labor.
Gains from Diversification: Example
   World Portfolios
     Countries  able to reduce variation in income
      through owning a portion of other country’s
      capital stock.
     Total output in the world is the same, yet each
      reduces the variance in overall income.
        In state 1, country A experiences low income from
         capital and labor. At the same time, country B
         experience high income from capital and labor.
        If country A owns 50% of country B’s capital stock,
         then it receives 50% of the income earned on this
         capital in country B.
        Capital income is smoothed; labor income isn’t.
Gains from Diversification:
Example
   World Portfolios
     Macroeconomic          aggregates in different states
     State 1     Home output GNI & GDP   Capital income  TB & NFIA
     Country A   Low         GNI > GDP   Payments from B TB < 0
                                                         NFIA > 0
     Country B   High        GNI < GDP   Payments to A   TB > 0
                                                         NFIA < 0
     State 2
     Country A   High        GNI < GDP   Payments to B   TB > 0
                                                         NFIA < 0
     Country B   Low         GNI > GDP   Payments from A TB < 0
                                                         NFIA > 0
Gains from Diversification: Example
   World Portfolios
     Capital   income over time
Gains from Diversification:
   Generalizing
     Countries   can only reduce volatility if output
      shocks are negatively correlated across
      countries (asymmetric).
     If both countries suffer a negative shock at the
      same time, they are unable to use
      diversification to reduce volatility in income.
      These shocks are known as common shocks
      (identical or symmetric).
     If output shocks become increasingly
      common across countries, then the gains
      from diversification are diminished.
The Home Bias Puzzle
   Home Bias
     Thetendency for investors to own a
     disproportionate share of their wealth in home
     assets, versus foreign assets.
       Home bias identified by comparing risk and return
        for sample portfolios available to U.S. investors.
       1970–1990: U.S. investors actually invested
        roughly 8% of their wealth abroad.
             They could have increased their return without increasing
              risk.
             A share of 40–60% in foreign assets would have
              increased the return while reducing risk.
The Home Bias Puzzle
   Home Bias—sample portfolios
The Home Bias Puzzle
   Why the home bias?
     Revisit   the assumptions used in the model:
        Cost of acquiring foreign assets (information
         barriers, trading costs)
        Asymmetry in consumption patterns across
         countries (home bias in consumption and
         nontraded goods)
        Concern about regulations, laws, institutions and
         risk of asymmetric/adverse treatment of foreign
         investors.
     Re-examine      the data after 1990.
          Perhaps global deregulation during the late 1980s
           and 1990s has been slow to take effect.

				
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