The Intertemporal Approach to Current Account

Determination
A Simple Two-period Model

Qing Liu

Dept. of Economics, CUHK

Spring 2014

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De…cits and Surpluses: The Balance of Payments
Elasticities approach to CA
A country sells a good x, and purchases a good m
Home demand for imports:

M (pm E /px ), M 0 < 0

Foreign demand for exports:

X (pm E /px ), X 0 > 0

The current account can be written as

X (pm E /px )(px /E ) pm M (pm E /px )

Assume constant relative price (pm /px = 1)

NX (E ) X (E )(px /E ) pm M ( E )

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Marshall-Lerner condition

net exporting:

NX (E ) X (E )(px /E ) pm M ( E )

dNX (E ) px X 0 px X
) = pm M 0
dE E E2

0 0
De…ne: η x = XXE ; η m = MME ;
assuming balanced trade: EM = X .

dNX (E ) px X
) = (η x + η m 1)
dE E2

A devaluation will improve the current account if the sum of the two
elasticities exceed unity

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Problem with Elasticities approach

Only a partial equilibrium

Y is constant
Constant relative price
Empirically not appealing

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Y-C-I-G approach to CA

A country sells a good x, and purchases a good m

Trade balance: NX (Y , E ), NX1 < 0, NX2 > 0
A simple Keynesian framwork

Y = C (Y ) + I (r ) + G + NX (Y , E )

M
= L(Y , r )
P
Fixed rate regime – Y and r
Flexible rate regime, NX (Y , E ) = 0
Complete isolation from the rest of world!

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Problem with Y-C-I-G approach

Completely short run

CA is just a residue!
An economy can run a trade de…cit forever
No dynamics!
Lack of a micro-founded framework
No optimal decision making!

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Modern view of current account

Current account is a central issue in open economy macroeconomics

Classic approach is unsatisfactory and subject to Lucas’s critique
Modern approach to currency account
Forward looking
Intertemporal choices of saving and investment
Optimizing behavior
Microfoundations

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A simple 2-period model of CA

A large number of identical consumers: representative agent

Agent lives for two period: t = 1, 2
Perfect foresight
No uncertainty
One goods: tradable; non-storable
Pure exchange: no production
Perfect capital mobility: r

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Basic Set-up

Preference:
U (C1 ) + βU (C2 ), U 0 > 0

Budget constraints:

C 1 + A2 = Y1 + ( 1 + r ) A1
C 2 = Y2 + ( 1 + r ) A2

A1 is the initial stock of net foreign assets

A2 is the new stock at the end of period 1

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A few concepts

GDP: Y1
GNP: Y1 + rA
Trade Surplus: TB1 = Y1 C1
Current account surplus:

CA1 = TB1 + rA1 = Y1 C1 + rA1 = A2 A1

Current account = Savings

Capital Account: KA1 = A1 A2

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Representative agent’s problem

the consumer’s maximization problem can be written as:

max U (C1 ) + βU (C2 )

fc1 ,c2 g

s.t.

C 1 + A2 = Y1 + ( 1 + r ) A1
C 2 = Y2 + ( 1 + r ) A2

Intertemporal Budget Constraint:

1 1
C1 + C2 = Y1 + (1 + r )A1 + Y2
1+r 1+r

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Optimal consumption

Lagrange:
1
max L = U (C1 ) + βU (C2 ) + λ(Y1 C1 + ( Y2 C 2 ) + ( 1 + r ) A1 )
fct ,λg 1+r

intertemporal Euler equation:

U 0 ( C1 ) = β ( 1 + r ) U 0 ( C2 )

it determines the path of consumption and therefore the dynamics of

the trade balance and current account!

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Key Questions

1 What determines the current account position of a country?

2 What factors will lead to changes in the current account?
3 What are the gains from trade?
4 How does government impact on the current account?

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Conditions for CA surplus and de…cit

Optimal consumption path:

U 0 ( C1 )
1+r =
βU 0 (C2 )

Autarky real interest rate:

U 0 ( Y1 )
1 + ra =
βU 0 (Y2 )

if r α > r , Y1 C1 < 0
if r α < r , Y1 C1 > 0
Implication
Country that is growing faster should have a current account de…cit,
since it should have a higher r a
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E¤ect of Shocks on CA

Special case: β(1 + r ) = 1

Y1 ( 1 + r ) + Y2
) C1 = C2 =
2+r
(Y1 Y2 )
CA =
2+r

A temporary increase in income will lead to CA surplus

The current account should be procyclical!
A permanent increase will have no e¤ect on CA!

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The gains from trade
Always gains from trade as long as r α 6= r
Welfare

Under perfect capital mobility,

1+r Y2 1 β
C = ( Y1 + )= Y1 + Y2
2+r 1+r 1+β 1+β

Since utility function is concave

1 β
u (C ) > u ( Y1 ) + u ( Y2 )
1+β 1+β
i.e., u (C ) + βu (C ) > u (Y1 ) + βu (Y2 )

Financial autarky is socially costly

Higher volatility of output, the higher welfare cost

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Insights

Economic integration is welfare-improving

Perfect capital mobility:

y1 #! c, CA #

No capital mobility:
y1 #! CA, c #, r α "

Real world lies somewhere in between above two extreme

y1 #! CA #, c #, r α "

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Introducing government

Government …nances spending with taxes and debts

Budget constraint for private sector:

C1 + A2 = Y1 T1
C2 = Y2 + (1 + r )A2 T2

Budget constraint for government:

T1 + B2 = G1
T2 = (1 + r )B2 + G2

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Intertemporal budget constraint

Private sector:
1 1
C1 + C 2 = ( Y1 T1 ) + ( Y2 T2 )
1+r 1+r
Government:
1 1
G1 + G2 = T1 + T2
1+r 1+r

only present value of expenditure matter (Ricardian Equivalence)

Economy’s budget constraint is independent of taxes
1 1
C1 + C2 = (Y1 G1 ) + (Y2 G2 )
1+r 1+r

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Government’s impact

Optimal consumption:

(Y1 G1 )(1 + r ) + (Y2 G2 )

C1 =
2+r

Current account:

( Y1 G1 ) ( Y2 G2 )
CA1 =
2+r

A government de…cit that leaves the path of spending unchanged has

no impact on CA
A permanent rise in G will have no impact on CA; a temporary rise in
G will lead to a deterioration in CA

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Introducing investment

Much of 4CA is driven by borrowing and lending that …nance

investment
Labor is still kept …xed; Output is produced from capital with DRS
technology
Yt = F (Kt )

Rate of physical depreciation in the capital stock is zero

Kt +1 = Kt + It

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Budget constraint and Current account

New budget constraint:

Ct + At +1 + (Kt +1 Kt ) = Yt + (1 + r )At

Current account:

CAt = At +1 At = Yt + rAt Ct (Kt +1 Kt ) = St It

It’s a fundamentally intertemporal phenomenon

Intertemporal budget constraint for 2 period model

C2 + I 2 F (K2 )
C1 + It + = F (K1 ) +
1+r 1+r

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Representative agent’s problem

The consumer’s maximization problem can be written as:

max U (C1 ) + βU (C2 )

fc1 ,c2 ,K 2 g

s.t.
C1 + A2 + K2 K1 = F (K1 )
C2 = F (K2 ) + K2 + (1 + r )A2

Intertemporal Budget Constraint:

C2 K2 F (K2 )
C1 + (K2 K1 ) + = F (K1 ) +
1+r 1+r

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Optimal decision

Lagrange:
F (K 2 ) C 2 +K 2
max L = U (C 1 ) + βU (C 2 ) + λ[F (K 1 ) C 1 (K 2 K 1 )+ 1 +r ]
fc1 ,c2 ,K 2 g

intertemporal Euler equation:

U 0 (C1 ) = β(1 + r )U 0 (C2 )

E¢ cient investment rule:

F 0 (K2 ) = r

)Fisher’s separation hypothesis’!

investment is independent of consumption!

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Fisher’s Separation Hypothesis

Desired capital stock is independent of domestic consumption

preference!
F 0 (K2 ) = r

Key assumptions:
Small open economy!
The economy consumes and produces a single tradable goods
Perfect capital mobility!

U 0 (C1a )
1 + r a = 1 + F 0 (K2a ) =
βU 0 (C2a )

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Pattern of CA

The patter of CA is still determined by the di¤erence between autarky

and world interest rate
if r a > r , CA1 < 0
if r a < r , CA1 > 0
note that, r a > r ) C1 " as well as I1 "
The country not only borrows to consume, also to invest
CA can be counter-cyclical!

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Implication
Investment incentives can actually make the economy worse o¤ than
in the absence of trade at all!

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A Two-region World Economy

World economy consisted of two countries with the basic set-up we

discussed earlier
The world interest rate, r , will be determined in a general equilibrium

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Equilibrium Conditions

home country:
U 0 ( C1 ) = β ( 1 + r ) U 0 ( C2 ) ;
c2 Y2
C1 + = Y1 + .
1+r 1+r
) U 0 (C1 ) = β(1 + r )U 0 (Y2 + (1 + r )(Y1 C1 ))
) dC 1 Y 1 C 1 σ C 2 / (1 +r ) U0
dr = 1 +r +(C /C )
2 1
,where σ = CU 00

foreign country:
U 0 ( C1 ) = β ( 1 + r ) U 0 ( C2 ) ;
C2 Y
C1 + = Y1 + 2 .
1+r 1+r

market clearing:

C 1 + C 1 = Y1 + Y1 ) S + S = 0

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Impact of a change in r
r can be interpreted as TOT for a country
r increases, lender is better o¤
r decreases, borrower is better o¤

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Determination of r and CA
dC 1 Y 1 C 1 σC 2 /(1 +r ) U0
note that dr = 1 +r +(C 2 /C 1 )
,where σ= CU 00

(i )r a < r < r a (ii )r a < r , CA > 0 (iii )r a > r , CA < 0

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A increase in Y1 (Y2)
U 0 (Y 1 )
1 + ra = βU 0 (Y 2 )

Y1 ") r a #, r #, CA ", CA # (how about Y2 ?)

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Welfare implication on growth

Suppose Home’s (lender) date 1 output increases

World interest falls
The intertemporal terms of trade of Home worsen
Home may lose in spite of the primary bene…t to home of higher date 1
output (immiserizing growth)
Welfare of Foreign (borrower) unambiguously rises
Suppose Home’s (lender) date 2 output increases
World interest increases
Foreign loses
Home gains: increase in output as well as better o¤ in TOT

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Two-country model with investment

Now the two countries’outputs are endogenously determined by

following technologies:

Y = AF (K ); Y = A F (K )
CA and r are determined by both SS schedule and investment decision

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Equilibrium Conditions

home country:
U 0 (C1 ) = β(1 + r )U 0 (C2 );
c2 Y2
C1 + 1 + R = Y1 + 1 + r .
foreign country:
U 0 ( C1 ) = β ( 1 + r ) U 0 ( C2 ) ;
C Y
C1 + 1 +2r = Y1 + 1 +2r .
investment rule:
A2 F 0 (K2 ) = r ,
A2 F 0 (K2 ) = r ;
market clearing:
C1 + C1 + I1 + I1 = Y1 + Y1 ) (S I ) + (S I )=0

dC1 Y C1 σC2 /(1 + r )

) = 1
dr 1 + r + (C2 /C1 )

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Determination of r and CA

(i )r α < r < r α (ii )r α < r , CA > 0 (iii )r α > r , CA < 0

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Non-separation of Investment from Saving

β #! SS #! r "! I #, I #, S #, S "

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E¤ect of productivity shift

A1 "! SS "! r #! I ", I "; CA ", CA #

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E¤ect of productivity shift

A2 "! SS #, I "! r "! I ?, I #; CA #, CA "

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