External Adjustment in Small and Large Economies

1
External Adjustment in Smalland Large Economies

• Roberto Chang
• Econ 336
• February 2007

2

• At the end of the last chapter, we noticed that
  one can derive an investment schedule and a
  savings schedule.

3
The Savings Function
Interest Rate
S
r
S
S
Savings
4
Interest Rate
An increase in savings. This may be due to higher
Y(1).
S
S
S
S
Savings
5
The Investment Function
Interest Rate
I
r
I
I
Investment
6
An increase in investment, May be due to an
increase in the future MPK
Interest Rate
I
I
r
I
I
I
I
Investment
7

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

8
Savings and Investment
Interest Rate
I
S
S
I
S, I
9
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
10
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
11
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
12
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
13
Interest Rate
I
S
I
S
S, I
14
The Current Account Diagram
Interest Rate
Interest Rate
CA
I
S
I
S
CA S - I
0
S, I
15
If the world interest rate is rA, the CA is zero
CA
I
S
rA
I
S
0
CA
S, I
16
If the world interest rate is r, the CA is in
deficit
CA
I
S
rA
r
I
S
0
CA
S, I
17
If the world interest rate is r, the CA is in
deficit
CA
I
S
rA
r
I
S
0
CA
S, I
18
If the world interest rate is r, the CA is in
surplus
CA
I
S
r
rA
I
S
0
CA
S, I
19

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

20
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S
I
S
CA S - I
0
S, I
21
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S
S
I
S
S
CA S - I
0
S, I
22
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S
S
CA
I
S
S
CA S - I
0
S, I
23
The CA improves, given r
Interest Rate
Interest Rate
CA
I
S
S
CA
r
I
S
S
CA S - I
0
S, I
24
An Increase in Investment
Interest Rate
Interest Rate
CA
I
S
I
S
CA S - I
0
S, I
25
An Increase in Investment
Interest Rate
Interest Rate
CA
I
S
I
S
CA S - I
0
S, I
26
The CA deteriorates
Interest Rate
Interest Rate
CA
I
S
I
S
CA S - I
0
S, I
27

• 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).

28
An increase in the future MPK (investment surge)
Interest Rate
Interest Rate
CA
I
S
CA
I
S
CA S - I
0
S, I
29
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 S - I
CA
0
CA
S, I
30
World Equilibrium
31

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

32
The US CA schedule
CAUS
US Current Account
33
The ROW CA schedule
CAROW
ROW Current Account
34

• 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.

35
Interest rate
CAROW
-

36
The ROW CA schedule
Interest Rate
CAROW
-

37
The ROW CA schedule
Interest Rate
CAROW
r
-

CA Surplus in ROW
38
The ROW CA schedule
Interest Rate
CAROW
r
-

CA Deficit in ROW
39

• 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

40
The US CA schedule
CAUS
US Current Account
41
Add the ROW CA schedule
CAUS
CAROW
US Current Account
ROW CA
42
The world interest rate Is r
CAUS
CAROW
r
US Current Account
ROW CA
43
The world interest rate Is r
CAUS
CAROW
r
US Current Account
ROW CA
US CA deficit ROW CA surplus
44
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)

45
CAUS
CAROW
r
US Current Account
ROW CA
US CA deficit ROW CA surplus
46
A fall in the US savings rate causes the CA
schedule to move to the left.
CAUS
CAROW
r
US Current Account
ROW CA
US CA deficit ROW CA surplus
47
The US CA deficit increases, and the world
interest rate goes up
CAUS
CAROW
r
r
US Current Account
New US CA deficit
48
CAUS
CAROW
r
US Current Account
ROW CA
US CA deficit ROW CA surplus
49
Increased savings in ROW move the CAROW schedule
to the left
CAUS
CAROW
CAROW
r
US Current Account
ROW CA
US CA deficit ROW CA surplus
50
The US CA deficit widens, and the interest rate
falls.
CAUS
CAROW
CAROW
r
r
US Current Account
ROW CA
The US CA deficit increases
51
The Role of Fiscal Policy
52

• 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.

53

• Under these assumptions, the analysis is exactly
  the same as if the households income in period 1
  had fallen by T(1) G(1).

54
A Tax financed increase in G(1) Effects at Home
Interest Rate
Interest Rate
CAUS
I
S
I
S
CA S - I
0
S, I
55
A Tax financed increase in G(1) Effects at Home
Interest Rate
Interest Rate
CAUS
I
S
I
S
CA S - I
0
S, I
56
Effect on World Equilibrium
New CAUS
CAROW
CAUS
r
r
US Current Account
New US CA deficit
57

• 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.

58

• 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.

59

• 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!!

60
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.

61

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

62
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.

63
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.

64
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).

65

• 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
  Chinas exchange rate policy) and weak growth in
  several other large economies (such as Germany)
  that led to greater net capital outflows from
  these countries.

66
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 regions future growth.

67

• In addition, the chapter makes two broader
  points. First, global capital flowsthe flow of
  saving and investment among countriesshould 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.

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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. 

69

• 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.