Macroeconomics MEDEG, UC3M Lecture 8: The Open Economy Hernán D. Seoane UC3M Spring, 2016 Introduction • We just learned some building blocks of modern macro, mainly used in a closed economy environment • Now we will learn about open economies • The road map for the approach to open economies will be: data, small open economy models, large open economy models • Later if we have time we focus also on some topics such as the external adjustment, capital integration, monetary policy and exchange rates Introduction • Large current account deficits. How do we know they are sustainable? • In other words, can a country run perpetual trade balance and current account deficits? • We show that if an economy started with debt, it cannot run a trade deficit forever, but it can run a current account deficit forever if the economy last infinite periods • What determines trade balance and current account? • We approach this question with a model similar to the consumption theory we developed some classes ago Small open economy • An open economy trades goods and services with the rest of the world • It is small if it cannot affect prices nor international rates • Size and population may not be correlated with economic size • Start looking at a 2 period small open economy • Chapter 3, International Macro (Schmitt-Grohe, Uribe and Woodford, 2016) Small open economy • People live for 2 periods and receive Q1 and Q2 as endowments of a unique perishable good for period 1 and 2 • Households have B0∗ units of bonds that pay r0 • In period 1 household’s income is r0 B0∗ + Q1 • They can use the income to purchase C1 or bonds B1∗ − B0∗ . The Budget constraint is C1 + B1∗ − B0∗ = r0 B0∗ + Q1 • In period 2 C2 + B2∗ − B1∗ = r1 B1∗ + Q2 Small open economy • If the world lasts for 2 periods, we know that B2∗ = 0 • The intertemporal Budget Constraint is given by C1 + Q2 C2 = (1 + r0 )B0∗ + Q1 + 1 + r1 1 + r1 • The present discounted value of consumption equals the present discounted value of intertemporal income. To make things simpler, assume B0∗ = 0 • What’s the shape of the Intertemporal Budget Constraint? Small open economy • Assume standard utility function, i.e. preferences can be represented by a map of indifference curves U (C1 , C2 ) • INSERT FIGURE • Solve Lagrangean Small open economy • Optimality implies that U1 (C1 , C2 ) = (1 + r1 )U2 (C1 , C2 ) • The slope of the indifference curve has to equal the interest rate • Why is this optimal? Intuition? If consumption in period 1 falls, utility falls by U1 (C1 , C2 ) • The drop in consumption is saved in bonds, which pay a return of r1 • This extra consumption increases utility marginally, in U2 (C1 , C2 ) units each, so that utility in period 2 increases by (1 + r1 )U2 (C1 , C2 ) Small Open Economy • Households are identical, so we can study the representative household • The country has access to international financial markets • The equilibrium interest rate r1 has to be equal to the world interest rate r1 = r∗ • This means that the interest rate parity holds • Note that Bt∗ is the net foreign asset position at the end of period t Small Open Economy • Define equilibrium • An equilibrium is a consumption bundle (C1 , C2 ), and an interest rate r1 that satisfies the country’s intertemporal budget constraint • The first order conditions are then U1 (C1 , C2 ) = (1 + r1 )U2 (C1 , C2 ) C1 + C2 Q2 = (1 + r0 )B0∗ + Q1 + 1 + r1 1 + r1 and r1 = r∗ Small Open Economy • Note (1 + r0 )B0∗ = −(Q1 − C1 ) − Q2 − C2 1 + r1 and, as we already know (1 + r0 )B0∗ = −(TB1 ) − TB2 1 + r∗ or (1 + r0 )B0∗ = −(CA1 − r0 B0∗ ) − CA2 − r∗ B1∗ 1 + r∗ Output shocks • How does the economy respond to output shocks? • Temporary versus permanent shocks have different impacts Temporary Output shocks • Adjustment to a temporary negative output shock • Temporary versus permanent shocks have different impacts • Assume a negative shock to output in period 1 equal to ∆ • The first endowment point was (Q1 , Q2 ) and now (Q1 − ∆, Q2 ) • If the interest rate is unchanged (and it is because it’s not affected by the small open economy) the two budget lines are parallel • If both C1 and C2 are normal goods, households will reduce both consumption levels and still try to smooth the shock out • But output did not fall in period 2, so the country is borrowing on part of future output to smooth consumption Temporary Output shocks • INSERT FIGURE • the economy runs a higher trade deficit in period one • Current account deteriorates in period one • In period 2 the economy has to generate a large trade surplus (larger than the one it would have produced without the shock) • large responses of TB and CA to temporary shocks Permanent Output shocks • Adjustment to a permanent negative output shock • Assume a negative shock to output in period 1 and 2 equal to ∆ • The first endowment point was (Q1 , Q2 ) and now (Q1 − ∆, Q2 − ∆) • Notice that here you are permanently more poor • After this shock, usually consumption in both periods adjust by ∆ and no effect is observed in the trade balance and the current account • Economies will finance temporary shocks, but will necessarily adjust to permanent shocks Permanent Output shocks • INSERT FIGURE Terms of trade shocks • So far Q1 and Q2 is a unique good that can be consumed or exported • Bundle of export goods is usually different from consumptions goods and import goods • But terms of trade are super important in many economies, specially in emerging economies or in economies with natural resources • Argentina suffers when soy prices fall; Venezuela and Russia suffer a lot when oil prices fall Terms of trade shocks • We modify our setup • Consumption and export goods are different • Households’ endowment is of oil, and they want to consume food • PM and PX denote the price of imports and the price of exports X • Terms of trade TT = PM P • An increase in the terms of trade means the price of the good a country exports increases compared to the price of the good a country imports Terms of trade shocks • The new budget constraints are C1 + B1∗ − B0∗ = r0 B0∗ + TT1 Q1 C2 + B2∗ − B1∗ = r1 B1∗ + TT2 Q2 • The intertemporal budget constraint C1 + C2 TT Q = (1 + r0 )B0∗ + TT1 Q1 + 2 2 1 + r1 1 + r1 Permanent vs Transitory Terms of trade shocks • Notice that TT affects the budget constraint in a way similar to output • Temporary TT falls induce agents to issue debt to smooth consumption • Permanent shocks induce agents to adjust consumption levels Imperfect information • Problem, who knows when a shock is permanent or transitory? • Expectations matter Interest rate shocks • A question we have been avoiding so far is what is the international interest rate • Up to which extent is it ok to consider it fixed? • Risk free rate • The actual rate some countries might actually pay can be different from the risk free one • rt = r∗ + p(B, Q1 , Q2 , ?) • Risk free rate plus a premium • Exogeneity and andogeneity of the premium? Interest rate shocks • An increase in the foreign rate has two effects • Makes savings more attractive: SUBSTITUTION EFFECT • Makes debtors more poor and creditors richer: INCOME EFFECT • if you are a debtor the increase in the interest rate makes you consume less today • if you are a lender, substitution effect and income effect go in opposite directions Interest rate shocks • INSERT FIGURE Capital controls • Current account deficits are no good nor bad per se • However, sometimes they are perceived as a negative sign and some countries intend to impose ways of controlling them • Capital controls are a way of doing so, kind of very famous in many places (Venezuela and Argentina, lately have impose strong constraints on the amount of resources people can send abroad, that basically affects payments for imports, distribution of dividends by foreign firms or by firms with foreign owners, etc) • In a very stylized way, our model allow us to say something about the impact of capital controls, although this is going to be very stylized, because in our setup the economies have no frictions • With some frictions or externalities, conclusions will certainly change Capital controls • INSERT FIGURES
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