external adjustment in small and large economies roberto chang econ 336 march 2012

External Adjustment in Smalland Large Economies

Roberto Chang

Econ 336

March 2012

• As mentioned in class, the last decade witnessed increased global imbalances

• Also, a fall in world interest rates

USA: Current Account (% of GDP)

Source: Bureau of Economic Analysis (BEA)

-0.07

-0.06

-0.05

-0.04

-0.03

-0.02

-0.01

0

0.01

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Real Interest Rates, 1999-2006

10-Year 3-7/8% Treasury Inflation-Indexed Note. Source: FRED, Federal Reserve Bank of St. Louis

Source: Lane and Milesi Ferreti 2006

• We will use the theory discussed in class to interpret these developments.

• The starting point is the investment schedule and the savings schedule, which we derived already.

Savings

r*

S

S

The Savings FunctionInterestRate

S*

Savings

Interest Rate

S

S

An increase in savings.This may be due tohigher Y(1).

S’

S’

Investment

r*

The Investment FunctionInterestRate

I*

I

I

Investment

r*

An increase in investment, May be due to an increase in the future MPK

InterestRate

I*

I

I

I’

I’

I**

• Recall that the current account is equal to savings minus investment. This suggests putting the two schedules together will give us the current account.

S, I

S

S

Savings and InvestmentInterestRate

I

I

S, I

S

S


I

I

r*

S* I*

If the world interest rateis r*, savings are S* andinvestment I*

S, I

S

S


I

I

r*

S* I*

The current account isCA* = S* - I* (a deficit)

CA Deficit

S, I

S

S


I

I

r*

S* I*

If the world interest rateincreases to r**, savings increase to S** and investmentfalls to I**

r**

I** S**

S, I

S

S


I

I

r*

S* I*

The current account is now in surplus, Since CA** = S** - I**

r**

I** S**

CA Surplus

S, I

Interest Rate

S

SI

I

S, I

S

SI

I

CA

CA= S - I

The Current Account Diagram

0

Interest Rate Interest Rate

S, I

S

SI

I

0 CA

CA

rA

If the world interest rate is rA, the CA is zero

S, I

S

SI

I

0 CA

CA

rA

If the world interest rate is r*, the CA is in deficit

r*

S, I

S

SI

I

0 CA

CA

rA

If the world interest rate is r**, the CA is in surplus

r**

• Now we can ask the question: what can cause a CA deficit? An increase in savings? An increase in investment?

S, I

S

SI

I

CA

CA= S - I

An Increase in Savings

0


S, I

S

SI

I

CA

CA= S - I


0


S’

S’

S, I

S

SI

I

CA

CA= S - I


0


S’

S’CA’

S, I

S

SI

I

CA

CA= S - I

The CA improves, given r*

0


S’

S’CA’

r*

S, I

S

SI

I

CA

CA= S - I

An Increase in Investment

0


S, I

S

SI

I

CA

CA= S - I

The CA deteriorates

0


• Note that some changes may cause both the savings schedule and the investment schedule to shift

• For example, an increase in the future marginal productivity of capital causes investment to increase and savings to fall. (Savings fall because consumption today must increase, in anticipation of future income).

S, I

S

SI

I

CA

CA= S - I

An increase in the futureMPK (investment surge)

0


CA’’

S, I

S

SI

I

CA

CA= S - I

If the world interest rateIs r*, the deficit in current account is CA’’, not CA’

0

Interest Rate

r*

CA’’ CA’

World Equilibrium

• Assume two countries, US and rest of the world (ROW).

• It will be useful to graph their CA schedules in the same diagram.

The US CA schedule

US CurrentAccount

CAUS

The ROW CA schedule

ROW CurrentAccount

CAROW

• It is convenient, however, to measure the ROW CA in the opposite direction (i.e. positive to the left, negative to the right).

• We just “flip the axis.”

+

CAROW

-

Interest rate

The ROW CA schedule

+

CAROW

-

Interest Rate

The ROW CA schedule

+

CAROW

-

Interest Rate

r*

CA Surplus in ROW

The ROW CA schedule

+

CAROW

-

Interest Rate

r*

CA Deficit in ROW

• The world is in equilibrium if

CAUS + CAROW = 0

i.e. the US CA surplus or deficit is exactly matched by a ROW deficit or surplus.

• The world interest rate adjusts to ensure this equality

The US CA schedule

US CurrentAccount

CAUS

US CurrentAccount

CAUS

ROW CA

CAROW

Add the ROW CA schedule

US CurrentAccount

CAUS

ROW CA

CAROW

r*

The world interest rateIs r*

US CurrentAccount

CAUS

ROW CA

CAROW

r*

The world interest rateIs r*

US CA deficit =ROW CA surplus

Application: The US CA Problem

• We can use this apparatus to examine two possible explanations of the current US CA situation: low savings in the US, and a “savings glut” in the world (i.e. an increase in savings in the ROW)

US CurrentAccount

CAUS

ROW CA

CAROW

r*


US CurrentAccount

CAUS

ROW CA

CAROW

r*


A fall in the US savings ratecauses the CA schedule to move to the left.

US CurrentAccount

CAUS

CAROW

r**

New US CA deficit

The US CA deficit increases, and the world interest rate goes up

r*

US CurrentAccount

CAUS

ROW CA

CAROW

r*


US CurrentAccount

CAUS

ROW CA

CAROW

r*


Increased savings in ROW move the CAROW schedule to the left

CAROW’

US CurrentAccount

CAUS

ROW CA

CAROW

r*

The US CA deficit increases

The US CA deficit widens, and the interest rate falls.

CAROW’

r**

The Role of Fiscal Policy

• Suppose that the government must spend an amount G(1) in period 1

• Assume, for now, that this is financed via lump sum taxes T(1) = G(1) in period 1.

• Hence there is no fiscal deficit in period 1.

• Under these assumptions, the analysis is exactly the same as if the household’s income in period 1 had fallen by T(1) = G(1).

S, I

S

SI

I

CAUS

CA= S - I

A Tax financed increase in G(1):Effects at Home

0


US CurrentAccount

New CAUS

CAROW

r**

New US CA deficit

Effect on World Equilibrium

r*

CAUS

• One may ask the question: what would happen if G(1) were financed by increased government borrowing (i.e. a fiscal deficit) rather than taxes in period 1?

• By definition, this would reduce national savings, if other things were kept equal.

• However, other things are not equal.

• In particular, future taxes will have to increase to service the national debt.

• Households will recognize this fact and adjust (in this case, increase) their savings correspondingly.

• In fact, in theory households will increase savings so as to perfectly compensate for the anticipated increase in taxes due to the fiscal deficit.

• Hence private savings will increase exactly by the amount of the fiscal deficit

• But then national savings do not change!!

Ricardian Equivalence

• Recap: a deficit financed increase in government expenditure has the same effects as a tax financed increase in G(1).

• In this sense, fiscal deficits are irrelevant (once government expenditure is accounted for).

• This is known as Ricardian Equivalence.

• Chapter 5 of Schmitt Grohe and Uribe’s text discusses Ricardian Equivalence in some detail. (Please read.)

Why Ricardian Equivalence May Fail

• Households may face borrowing constraints.

• The households that benefit from current tax cuts may not be the ones that pay the necessary future tax increases.

• Taxes may be not be lump sum.

The Economic Report of the President, 2006

“In 2004 the United States ran a current account deficit of $668 billion. This deficit meant the United States imported more goods and services than it exported. The counterpart to the U.S. current account deficit was a U.S. capital account surplus. This surplus meant that foreign investors purchased more U.S. assets than U.S. investors purchased in foreign assets, investing more in the United States than the United States invested abroad. “

Is this statement justified?

“The size and persistence of U.S. net capital inflows reflects a number of U.S. economic strengths (such as its high growth rate and globally competitive economy) as well as some shortcomings (such as its low rate of domestic saving).”

“The recent rise in U.S. net capital inflows between 2002 and 2004 in part reflects global economic conditions (such as a large increase in crude oil prices) as well as policies (such as China’s exchange rate policy) and weak growth in several other large economies (such as Germany) that led to greater net capital outflows from these countries.”

Lessons for policy?

“Encouraging greater global balance of capital flows would be helped by steps in several countries. The United States should raise its domestic saving rate. Europe and Japan should improve their growth performance and become more attractive investment destinations. Greater exchange rate flexibility in Asia, including China, and financial sector reforms could increase the role of domestic demand in promoting that region’s future growth.”

“In addition, the chapter makes two broader points. First, global capital flows—the flow of saving and investment among countries—should be analyzed from a global perspective and not by considering U.S. economic policies alone. Global capital flows are jointly determined by the behavior of many countries. To understand why the United States receives large net capital inflows requires understanding why countries like Japan, Germany, China, and Russia experience large net capital outflows.

A second point is the need to distinguish between market-driven and policy-driven capital flows. “

An answer (Roubini)

“Having the Chutzpah to title this deficit as a capital account surplus and then go on for the entire chapter to interpret all of the global current account imbalances as a matter of capital exporting countries (i.e. countries who run current account surpluses) and capital importing countries (i.e. the few countries who run current account deficits) is to confuse cause and effect. ”

“…most of this "inflow" (call it more properly borrowing binge) is coming on net not from willing private foreign investors wanting to invest in U.S. assets but rather from political agents, i.e. foreign central banks that are oblivious to the low returns on U.S. Treasury bills and bonds (and capital losses once the dollar falls) and are lending cheaply to the U.S. Treasury. So much for the rest of the world wanting to buy U.S. assets and we thus generously running a current account deficit to accommodate this portfolio demand for U.S. assets.”

external adjustment in small and large economies roberto chang econ 336 march 2012

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