Macroeconomics MEDEG, UC3M - Lecture 8: The Open Economy

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