Download Intertemporal Approach to the Current Account

Current Account
Metzler Diagram
Savings and Investment Schedule
In a closed economy, current account is zero and interest rates
sets savings equal to investment.
r
SP + ( T-G)
rA
I
S,I
World Real Interest Rate




A relatively small open economy will not affect world
international financial markets.
Take the world interest rate as given.
If world interest rate is higher than autarky rate, then
country would have a current account surplus.
If world interest rate is lower than autarky rate, the
the country would have a current account deficit.
Current Account Surplus
r
SP + ( T-G)
rW
rA
I
S,I
Current Account Deficit
r
SP + ( T-G)
rA
I
rW
S,I
Current Account Surplus
r
SP + ( T-G)
rW
rA
I
S,I
What shifts the Current Account?
Temporary shock to income may change
savings profile.
 Example: Thailand and Sri Lanka are hit by
Tsunami. This reduces current income from
tourism, but since Tsunami’s happen only
once per 500 years, this does not affect future
marginal product of capital.

 Yt
falls relative to future, savings falls.
Current Account Surplus
r
SP + ( T-G)
rW
rA
I
S,I
What shifts the Current Account
surplus?
New technologies.
 Example: In the late 1990’s, US developed
several new high-tech industries related to
internet which offered a promise of high future
productivity (which was largely born out) and
income.

 Investment
high and savings low
Current Account Surplus
r
SP + ( T-G)
rW
rA
I
S,I
Twin deficits: What about changes in
the budget deficit?
Holding the response of private savings constant,
an increase in the budget deficit will shift national
savings
Examples
1. Government increases spending without increasing
taxes. Consumers do not adjust consumption.
2. Government cuts taxes without cutting G.
Consumers spend all of their tax cut on
consumption.

Ricardian Theory: Households are
forward looking in re fiscal policy.
If the government runs a deficit today, they must raise taxes in
the future. High future taxes will reduce the present value of
lifetime disposable income. Consumers should increase
savings today.
Examples:
1.
Government increases spending without increasing taxes,
people will know that taxes will go up in the future to pay back
debt, so they will cut back consumption.
2.
Government cuts taxes without cutting spending or spending
plans. If people know that taxes must rise in the future to pay
back debt, they will save any of their tax cut.

World Real Interest Rates
Any given economy may take real interest rate
as given.
 But the world is a closed economy, so world
real interest rates will be set by world saving
and investment.
 Changes in saving and investment in one
country may affect current account in another
country through interest rate.

Deficit of Savings in one country is large enough
to shift world savings curve.
[SP + ( T-G)]W’
[SP + ( T-G)]W
r
rA
rW
IW
S,I
Rise in world real interest rate will
change domestic current account
r
SP + ( T-G)
rW’
rW
I
S,I
In a number of episodes, US current
account deficits have been associated
with budget deficits
Budget and Current Account Deficits
4.00%
3.00%
2.00%
1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
19
98
20
00
20
02
19
94
19
96
19
88
19
90
19
92
-1.00%
19
84
19
86
19
80
19
82
% of GDP
0.00%
CA/Y
(T-G)/Y
Is today’s current account imbalance due to US
budget deficits? One counterargument is that
current real interest rates are low.
Real Interest Rate -USA
5.00
4.00
2.00
VALUE
1.00
Feb-05
Aug-04
Feb-04
Aug-03
Feb-03
Aug-02
Feb-02
Aug-01
Feb-01
Aug-00
Feb-00
Aug-99
Feb-99
Aug-98
Feb-98
-1.00
Aug-97
0.00
Feb-97
%
3.00
Demographics and Current Global
Imbalances.
In Japan and Korea, demographics suggest that
share of population in the prime working years may
be dropping over the next 2 decades.
Implications:
1. High savings rates due to demographic shifts will
decline.
2. Investment will also decline. If investment is
currently dropping more than saving, current
account will expand?

Current Account Surplus
r
SP + ( T-G)
rW
I
S,I
Summary: Macroeconomics from
Three Perspectives
1.
2.
3.
Long-term: Considered the determinants of
economic growth and GDP per person.
Short-term: Examined the behavior of demand,
interest rates and monetary policy, and exchange
rates at business cycle frequency.
Medium Term: Consider the fundamental exchange
rate when prices can adjust and the adjustment of
the current account to gaps between economic
supply and demand.
Final Exam
Date: Thursday May 19, 2005
 Time: 12:30-3:30
 Venue: LG1031
 Subject Matter: Cumulative of all lectures.
Approximately 70% on material after the
midterm.
 Bring: Calculator, pens, pencils.
