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External Adjustment in Small and Large Economies

External Adjustment in Small and Large Economies. Roberto Chang Econ 336 April 2013. The last decade witnessed increased global imbalances , especially prior to the global financial crisis. Also , a fall in world interest rates. USA: Current Account (% of GDP) .

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External Adjustment in Small and Large Economies

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  1. External Adjustment in Smalland Large Economies Roberto Chang Econ 336 April 2013

  2. Thelastdecadewitnessedincreased global imbalances, especially prior tothe global financial crisis. • Also, a fall in worldinterestrates

  3. USA: Current Account (% of GDP) Source: Bureau of Economic Analysis (BEA)

  4. Real Interest Rates, 1999-2006 10-Year 3-7/8% Treasury Inflation-Indexed Note. Source: FRED, Federal Reserve Bank of St. Louis

  5. Source: Lane and Milesi Ferreti 2006

  6. Source: Lane and Milesi Ferreti 2006

  7. We can use thetheorydiscussed in classtointerpretthesedevelopments. • Weend up with a theory of worldequilibrium. • Mainreference: SU, ch. 4 • The starting point is the investment schedule and the savings schedule, which we derived already.

  8. The Savings Function Interest Rate S r* S S* Savings

  9. Interest Rate An increase in savings. This may be due to higher Y(1). S S’ S S’ Savings

  10. The Investment Function Interest Rate I r* I I* Investment

  11. An increase in investment, May be due to an increase in the future MPK Interest Rate I’ I r* I’ I I* I** Investment

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

  13. Savings and Investment Interest Rate I S S I S, I

  14. Savings and Investment Interest Rate I S If the world interest rate is r*, savings are S* and investment I* r* S I S* I* S, I

  15. Savings and Investment Interest Rate I S The current account is CA* = S* - I* (a deficit) r* S I S* I* S, I CA Deficit

  16. Savings and Investment Interest Rate I S r** If the world interest rate increases to r**, savings increase to S** and investment falls to I** r* S I I** S** S* I* S, I

  17. Savings and Investment Interest Rate I S r** The current account is now in surplus, Since CA** = S** - I** r* S I I** S** S* I* S, I CA Surplus

  18. Interest Rate I S I S S, I

  19. The Current Account Diagram Interest Rate Interest Rate CA I S I S CA = S - I 0 S, I

  20. If the world interest rate is rA, the CA is zero CA I S rA I S 0 CA S, I

  21. If the world interest rate is r*, the CA is in deficit CA I S rA r* I S 0 CA S, I

  22. If the world interest rate is r*, the CA is in deficit CA I S rA r* I S 0 CA S, I

  23. If the world interest rate is r**, the CA is in surplus CA I S r** rA I S 0 CA S, I

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

  25. An Increase in Savings Interest Rate Interest Rate CA I S I S CA = S - I 0 S, I

  26. An Increase in Savings Interest Rate Interest Rate CA I S’ S I S S’ CA = S - I 0 S, I

  27. An Increase in Savings Interest Rate Interest Rate CA I S’ S CA’ I S S’ CA = S - I 0 S, I

  28. The CA improves, given r* Interest Rate Interest Rate CA I S’ S CA’ r* I S S’ CA = S - I 0 S, I

  29. An Increase in Investment Interest Rate Interest Rate CA I S I S CA = S - I 0 S, I

  30. An Increase in Investment Interest Rate Interest Rate CA I S I S CA = S - I 0 S, I

  31. The CA deteriorates Interest Rate Interest Rate CA I S I S CA = S - I 0 S, I

  32. 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).

  33. An increase in the future MPK (investment surge) Interest Rate Interest Rate CA I S CA’’ I S CA = S - I 0 S, I

  34. If the world interest rate Is r*, the deficit in current account is CA’’, not CA’ Interest Rate CA I S r* I S CA’ CA = S - I CA’’ 0 S, I

  35. World Equilibrium

  36. Assume two countries, US and rest of the world (ROW). • It will be useful to graph their CA schedules in the same diagram.

  37. The US CA schedule CAUS US Current Account

  38. The ROW CA schedule CAROW ROW Current Account

  39. 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.”

  40. Interest rate CAROW - +

  41. The ROW CA schedule Interest Rate CAROW - +

  42. The ROW CA schedule Interest Rate CAROW r* - + CA Surplus in ROW

  43. The ROW CA schedule Interest Rate CAROW r* - + CA Deficit in ROW

  44. 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

  45. The US CA schedule CAUS US Current Account

  46. Add the ROW CA schedule CAUS CAROW ROW CA US Current Account

  47. The world interest rate Is r* CAUS CAROW r* ROW CA US Current Account

  48. The world interest rate Is r* CAUS CAROW r* ROW CA US Current Account US CA deficit = ROW CA surplus

  49. 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)

  50. CAUS CAROW r* ROW CA US Current Account US CA deficit = ROW CA surplus

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