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Lecture 2

Current Account & its sustainability

1

Review of Lecture 1

National Income Identities:

• 𝑌 = 𝐶 +𝐼 +𝐺 +𝐸𝑋 −𝐼𝑀 +𝑁𝐹𝐼 +𝑁𝑈𝑇 = 𝐶 +𝐼 +𝐺 +𝐶𝐴

transactions transactions

• 𝑪𝑨 = 𝑻𝑩 + 𝑵𝑭𝑰 + 𝑵𝑼𝑻

• 𝑪𝑨 = 𝑺 − 𝑰 = 𝑺𝑷 + 𝑺𝒈 − 𝑰 = 𝑺𝑷 + 𝑻 − 𝑮 − 𝑰

Fiscal

National Income Identity: Balance

• 𝑩𝑶𝑷 = 𝑪𝑨 + 𝑭𝑨 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑨𝒄𝒄𝒐𝒖𝒏𝒕

• 𝑪𝑨 = −𝑭𝑨 2

Learning Objectives

• Derived the optimal CA, from household utility maximization

• Describe the pros and cons of running a CA deficit

3

Part 1

4

Current Account Deficit

• Can the US run a perpetual trade deficit or current account

deficit?

5

Two-period Model: Net Foreign Wealth

• Consider an open economy that lasts for two periods. Assume

that all residents are identical, and they can only save in

internationally-traded bonds

• Let 𝑩𝒕 be net foreign wealth in period 𝑡.

• Net foreign wealth is the value of overseas assets owned

by a nation, minus the value of domestic assets owned by

foreigners, adjusted for changes in valuation and exchange

rates.

• 𝑩𝒕 > 𝟎: the country has positive foreign wealth (i.e. the

country is a net lender)

• 𝑩𝒕 < 𝟎: the country has negative foreign wealth (i.e. the

country is a net borrower)

6

Two-period Model: Net Foreign Wealth

Assume that all residents are identical, and they can only

save in internationally-traded bonds

• Net foreign wealth is the value of overseas assets

owned by a nation, minus the value of domestic assets

owned by foreigners, adjusted for changes in valuation

and exchange rates.

7

Active Learning 1

Two-period Model: Net Foreign Wealth

• 𝑩𝒕 > 𝟎: the country has

8

Two-period Model: Net Factor Income

period 𝒕 period 𝒕 + 𝟏

𝑩𝒕−𝟏 𝑩𝒕 𝑩𝒕+𝟏

holding) generates stable net factor income (i.e. interest) at

rate 𝑟:

𝑵𝑭𝑰𝒕 = 𝒓𝑩𝒕−𝟏

9

Two-period Model: Current Account Balance

• Let 𝑻𝑩𝒕 denotes the trade balance in period 𝑡, and 𝑪𝑨𝒕 the

current account balance in period 𝑡.

account is defined as the change of net foreign wealth:

𝑪𝑨𝒕 = 𝑩𝒕 − 𝑩𝒕−𝟏

factor income:

𝑪𝑨𝒕 = 𝑻𝑩𝒕 + 𝑵𝑭𝑰𝒕 = 𝑻𝑩𝒕 + 𝒓𝑩𝒕−𝟏

• Combine:

𝑩𝒕 = 𝑩𝒕−𝟏 + 𝑪𝑨𝒕 = 𝟏 + 𝒓 𝑩𝒕−𝟏 + 𝑻𝑩𝒕

10

Two-period Model: No-Ponzi-Game Condition

• For period 1:

𝑩𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑻𝑩𝟏

• For period 2:

𝑩𝟐 = 𝟏 + 𝒓 𝑩𝟏 + 𝑻𝑩𝟐

𝑩𝟐 𝑻𝑩𝟐

𝟏 + 𝒓 𝑩𝟎 = − 𝑻𝑩𝟏 −

𝟏+𝒓 𝟏+𝒓

• Since the economy lasts only two periods, 𝑩𝟐 = 𝟎.

𝑻𝑩𝟐

𝟏 + 𝒓 𝑩𝟎 = −𝑻𝑩𝟏 −

𝟏+𝒓 11

Active Learning 2: Perpetual Trade Deficit?

𝑻𝑩𝟐

𝟏 + 𝒓 𝑩𝟎 = −𝑻𝑩𝟏 −

𝟏+𝒓

• Can we have perpetual trade deficit? i.e. both 𝑻𝑩𝟏 and 𝑻𝑩𝟐

are negative?

a. If 𝑩𝟎 < 𝟎 and 𝑻𝑩𝟏 < 𝟎, then 𝑻𝑩𝟐

must be positive / must be negative / can be either.

b. If 𝑩𝟎 > 𝟎 and 𝑻𝑩𝟏 < 𝟎, then 𝑻𝑩𝟐

must be positive / must be negative / can be either.

12

Perpetual CA Deficit?

𝑪𝑨𝟐 − 𝒓𝑩𝟏

𝟏 + 𝒓 𝑩𝟎 = −(𝑪𝑨𝟏 − 𝒓𝑩𝟎 ) −

𝟏+𝒓

𝑪𝑨𝟐 − 𝒓𝑩𝟏

𝑩𝟎 = −𝑪𝑨𝟏 −

𝟏+𝒓

𝑪𝑨𝟏 = 𝑩𝟏 − 𝑩𝟎

𝑪𝑨𝟐 − 𝒓(𝑪𝑨𝟏 + 𝑩𝟎 )

𝑩𝟎 = − 𝑪𝑨𝟏 −

𝟏+𝒓

• Rearranging:

𝑩𝟎 = −𝑪𝑨𝟏 − 𝑪𝑨𝟐

13

Active Learning 3: Perpetual CA Deficit?

• From the No-Ponzi-game condition:

𝑩𝟎 = −𝑪𝑨𝟏 − 𝑪𝑨𝟐

and 𝑪𝑨𝟐 are negative?

a. If 𝑩𝟎 < 𝟎 and 𝑪𝑨𝟏 < 𝟎, then 𝑪𝑨𝟐

must be positive / must be negative / can be either.

b. If 𝑩𝟎 > 𝟎 and 𝑪𝑨𝟏 < 𝟎, then 𝑪𝑨𝟐

must be positive / must be negative / can be either.

14

Ponzi Game

• The game is named after Charles Ponzi, who used this

technique in the US during 1920s.

(1) the operator pays returns to its previous investors with the

capital raised from new investors, (2) rather than from

legitimate business.

• The Ponzi game is still played (e.g. the Swiss Cash scam in

2006).

end of life and borrowers must pay off all his debt in the end.

15

Ponzi Game

16

Madoff and His Ponzi game

York, was charged of operating a Ponzi game at his asset

management company in 2008.

an estimated loss of $64 billion for investors.

17

Can a Country Play Ponzi-game?

exists no international law enforcement for debt repayment.

long as other countries are willing to lend to it.

choose to default (sovereign default), and it happens!

18

Case Study: 1982 Mexican Sovereign Default

• In 1982, Mexico defaulted on its external debt obligations,

marking the beginning of the Developing Country Debt Crisis,

mainly among Latin American countries.

• External borrowing dried up; incomes dropped; growth

stagnated; unemployment rose.

• Reputation was seriously damaged, making future borrowing even

more difficult.

• Rising oil prices in the 1970s forced poorer countries to borrow

heavily. Meanwhile, OPEC deposited and "recycled" the capital as

loans.

IMF forced reforms and austerity measures.

19

Sovereign Default

20

Part 2

• Budget constraint

• Utility maximization

21

Model Setting

We extend the two-period model from part 1:

• By adding utility optimization into the problem

and live for two periods.

The household consumes, and save / borrow in international

market:

• 𝑸𝒕 : endowment in period t

• 𝑪𝒕 : consumption in period t

• 𝑩𝒕 : net wealth at the end of period t

• 𝒓𝒕 : interest rate in period t 22

Lifetime Budget Constraint

Household’s budget constraints are

𝑪𝟏 + 𝑩𝟏 = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏

𝑪𝟐 + 𝑩𝟐 = 𝟏 + 𝒓𝟏 𝑩𝟏 + 𝑸𝟐

𝑪𝟐 𝑸𝟐

No-Ponzi-game

𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +

𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏

Lifetime Budget Constraint

𝑨 is the endowment point.

The figure below is drawn, by assuming that 𝑩𝟎 = 𝟎.

𝑪𝟐

LBC of a representative household:

𝑪𝟐 𝑸𝟐

𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +

𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏

𝑸𝟐 𝑨

𝑪𝟏

𝑸𝟏

24

Utility Function

Household’s preference is described by utility function

𝑼 𝑪𝟏 , 𝑪𝟐 , which gives convex indifferent curve:

𝑪𝟐

Outward shift means higher utility level.

𝑪𝟏

25

Utility Optimization Problem

Such that

𝑪𝟐 𝑸𝟐

𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +

𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏

Note 𝑩𝟎 , 𝒓𝟎 , 𝒓𝟏 , 𝑸𝟏 , 𝑸𝟐 are exogenously given.

graph drawn in this example assume that 𝑩𝟎 = 𝟎.

26

Household’s Optimization Problem

At point 𝑩, marginal rate of substitution

𝑪𝟐 𝝏𝑼(𝑪𝟏 , 𝑪𝟐 )

𝑴𝑼𝑪𝟏 𝝏𝑪𝟏

𝑴𝑹𝑺 = = = 𝟏 + 𝒓𝟏

𝑴𝑼𝑪𝟐 𝝏𝑼(𝑪𝟏 , 𝑪𝟐 )

𝝏𝑪𝟐

Implicitly, 𝑩𝟎 = 𝟎.

𝑸𝟐

𝑨 𝑩

𝑪𝟐

𝑪𝟏

𝑸𝟏 𝑪𝟏

27

Country’s Optimization Problem

problem is the same as a household’s problem.

lending are in terms of internationally-traded bonds.

world interest rate as given: 𝒓𝟎 = 𝒓𝟏 = 𝒓.

28

Country’s Optimization Problem

𝑪𝟐 such that

𝑪𝟐 𝑸𝟐

𝑪𝟏 + = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +

𝟏+𝒓 𝟏+𝒓

Optimization:

𝑴𝑼𝑪𝟏

𝑴𝑹𝑺 = =𝟏+𝒓

𝑸𝟐 𝑴𝑼𝑪𝟐

𝑨 𝑩

𝑪𝟐

𝑪𝟏

𝑸𝟏 𝑪𝟏

29

Trade Balance

Recall the definitions:

𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎

𝑪𝑨𝟏 = 𝑩𝟏 − 𝑩𝟎

Thus,

𝑻𝑩𝟏 = (𝑩𝟏 − 𝑩𝟎 ) − 𝒓𝑩𝟎 = 𝑸𝟏 − 𝑪𝟏

budget constraint for period 1:

𝑪𝟏 + 𝑩𝟏 = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏

Similarly,

𝑻𝑩𝟐 = (𝑩𝟐 − 𝑩𝟏 ) − 𝒓𝑩𝟏 = 𝑸𝟐 − 𝑪𝟐

budget constraint for period 2:

𝑪𝟐 + 𝑩𝟐 = 𝟏 + 𝒓𝟏 𝑩𝟏 + 𝑸𝟐

30

Current Account Balance

In 1st period,

𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎 = 𝑸𝟏 − 𝑪𝟏 + 𝒓𝑩𝟎

In 2nd period,

𝑪𝑨𝟐 = 𝑻𝑩𝟐 + 𝒓𝑩𝟏 = 𝑸𝟐 − 𝑪𝟐 + 𝒓𝑩𝟏

Thus

𝑸𝟐 − 𝑪𝟐

𝑪𝑨𝟐 =

𝟏+𝒓

31

Example

Consider an economy with logarithmic preferences:

𝑪𝟐 𝑸𝟐

𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝑪𝟏 + = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +

𝟏+𝒓 𝟏+𝒓

Optimization condition is:

𝑴𝑼𝑪𝟏 𝑪𝟐

𝑴𝑹𝑺 = = =𝟏+𝒓

𝑴𝑼𝑪𝟐 𝑪𝟏

32

Example

Plug into budget constraint:

𝑪𝟐 𝑸𝟐

𝑪𝟏 + = 𝟐𝑪𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +

𝟏+𝒓 𝟏+𝒓

Solve it:

𝟏 𝑸𝟐

𝑪𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +

𝟐 𝟏+𝒓

𝟏 𝑸𝟐

𝑻𝑩𝟏 = 𝑸𝟏 − 𝑪𝟏 = 𝑸𝟏 − 𝟏 + 𝒓 𝑩𝟎 −

𝟐 𝟏+𝒓

𝟏 𝑸𝟐

𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎 = 𝒓𝑩𝟎 + 𝑸𝟏 − 𝟏 + 𝒓 𝑩𝟎 −

𝟐 𝟏+𝒓 33

The Impact of Shocks on CA

would each affect the CA of a small open economy?

interest rate

34

Shock in Endowment or Production 𝑸𝟏 ↓

𝑪𝟐

𝑨: original endowment point

𝑨′ 𝑨

𝑸′𝟐 = 𝑸𝟐

𝑪𝟏

𝑸′𝟏 𝑸𝟏

35

Shock in Endowment or Production 𝑸𝟏 ↓

𝑩: original consumption point

𝑪𝟐

𝑩′ : consumption point after the

shock

𝑨′ 𝑨 smooth consumption across

𝑸′𝟐 = 𝑸𝟐

𝑪𝟐 𝑩 periods

𝑪′𝟐 𝑩′

𝑪𝟏

𝑸′𝟏 𝑪′𝟏 𝑸𝟏 𝑪𝟏

36

Shock in World Interest Rate 𝒓 ↑

period.

saver, and reduces consumption if it is a borrower.

37

Shock in World Interest Rate 𝒓 ↑

𝑪𝟐

𝒓: original world interest rate

Slope −(𝒓′ + 𝟏)

𝑨 Slope −(𝒓 + 𝟏)

𝑸𝟐

𝑸𝟏 𝑪𝟏

38

Shock in World Interest Rate 𝒓 ↑

𝑪𝑨𝟏 ↑ and 𝑪𝑨𝟐 ↓ to smooth

𝑪𝟐 consumption across periods;

𝑪𝑨𝟏 ↑ and 𝑪𝑨𝟐 ↓ for both CA-deficit

and CA-surplus countries, because

we assume that substitution effect

dominates in the household

preferences.

𝑸𝟐

𝑨

𝑪′𝟐 𝑩′ 𝑩

𝑪𝟐

𝑸𝟏 𝑪′𝟏 𝑪𝟏 𝑪𝟏

39

Shock in World Interest Rate 𝒓 ↑

𝒓 ↑ → 𝑪𝟏 ↓ and 𝑩𝟏 ↑ → 𝑪𝑨𝟏 ↑

• Conversely,

𝒓 ↓ → 𝑪𝟏 ↑ and 𝑩𝟏 ↓ → 𝑪𝑨𝟏 ↓

• Then, what is the implication of US Quantitative Easing (QE)

for small open economies?

• Small open economies will reduce their CA balance

40

Is current CA deficit good or bad?

consumption smoothing

• E.g. when natural disasters happen.

• Lack of export competitiveness

• Lack of domestic saving, and hence, high dependency on

external financing (particularly short-term debt financing)

• Over-investment such as asset bubble

41

CA Deficit and Economic Crisis

• Large and persistent CA deficit often precedes economic

crisis.

Mexico ran a large CA deficit before the Tequila crisis in Dec 1994,

when sudden capital outflow made the peso depreciated roughly

50% against the dollar in one month.

42

CA Deficit and Economic Crisis

43

CA Deficit and Economic Crisis

The persistent CA deficit in the US prior to the Global financial crisis in 2008.

44

CA Deficit and Economic Crisis

The debt crisis began in 2008 with the collapse of Iceland's banking system. It spread

to other European countries such as Portugal, Italy, Ireland, Greece, and Spain in 2009.

45

CA Deficit and Economic Crisis

are more easily falling into economic crisis. Why?

• Investment funded by foreign money

• mounting external debt

• rising concerns over burst of asset bubble and borrower’s

ability to repay

• change in investor’s sentiment

• sudden capital outflows and “bank run”

• economic crisis

• Economists often consider a large and persistent CA deficit

as a warning sign/indicator.

46

Measures to Reduce CA Deficit

• Make America Great Again (U.S.)

• Cutting subsidy in imported oil (Indonesia)

• Tightening restrictions in gold imports (India)

• Promote domestic (private and public) saving:

• Fiscal consolidation after crisis (U.S. and Greece)

• Imposing restrictions on capital flows (Brazil and Korea)

47

Summary

• Two-period model setup

• CA sustainability and No-Ponzi-game condition

• Determination of optimal CA balance

• Pros and cons of CA deficit

48

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