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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
• 𝑪𝑨 = 𝑻𝑩 + 𝑵𝑭𝑰 + 𝑵𝑼𝑻
• 𝑪𝑨 = 𝑺 − 𝑰 = 𝑺𝑷 + 𝑺𝒈 − 𝑰 = 𝑺𝑷 + 𝑻 − 𝑮 − 𝑰
Fiscal
National Income Identity: Balance
• 𝑩𝑶𝑷 = 𝑪𝑨 + 𝑭𝑨 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑨𝒄𝒄𝒐𝒖𝒏𝒕
3
Part 1
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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)
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Two-period Model: Net Foreign Wealth
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Active Learning 1
Two-period Model: Net Foreign Wealth
• 𝑩𝒕 > 𝟎: the country has
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Two-period Model: Net Factor Income
period 𝒕 period 𝒕 + 𝟏
𝑩𝒕−𝟏 𝑩𝒕 𝑩𝒕+𝟏
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.
• 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.
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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
• The Ponzi game is still played (e.g. the Swiss Cash scam in
2006).
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Ponzi Game
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Madoff and His Ponzi game
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Can a Country Play Ponzi-game?
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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.
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Part 2
• Budget constraint
• Utility maximization
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
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.
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
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
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Example
Consider an economy with logarithmic preferences:
𝑪𝟐 𝑸𝟐
𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝑪𝟏 + = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +
𝟏+𝒓 𝟏+𝒓
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
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
𝑪𝟏
𝑸′𝟏 𝑪′𝟏 𝑸𝟏 𝑪𝟏
36
Shock in World Interest Rate 𝒓 ↑
37
Shock in World Interest Rate 𝒓 ↑
𝑪𝟐
𝒓: original world interest rate
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 ↑
40
Is current CA deficit good or bad?
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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
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
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Summary
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