Lecture 1: Intertemporal Trade in a Two-Period Model Tomáš Holub International Macroeconomics FSV UK, 16 February 2016

? Current account deficit is... … a result of exports falling short of imports.

? Current account deficit is... … a result of savings falling short of investments. Both definitions hold simultaneously, of course (but each of them may lead to us a different thinking about these issues).

Neoclassical Synthesis In these models, CA deficits reflects macroeconomic disequilibrium (economic overheating, low foreign demand, loss of price competitiveness). Safe level: CA deficit below 3-5 % of GDP (?); Must be addressed by economic policies. But, how is the equilibrium level  determined?

Example:CA Deficits and EU Economic Policy (EIP Scoreboard) Source: The scoreboard evaluates both external and internal imbalances; Among external imbalances, it looks at 3Y average of current account balance as a % of GDP, with thresholds +6/-4%; Another indicator is net international investment position as a % of GDP with a -35% thresholds; In other words, current account deviating too much from zero, as well as net international investment position being too negative, are viewed as a source of risk that should be addressed by economic policies.

Mundell-Fleming Model Assume perfect capital mobility and fixed ER; How to simultaneously achieve internal and external equilibrium? Hint: MP cannot be used in this situation; you may change the fixed ER and use fiscal policy.

Mundell-Fleming Model (ii) Assume perfect capital mobility and floating ER; How to simultaneously achieve internal and external equilibrium? Hint: ER cannot be used in this situation; you may use monetary and fiscal policy.

Neoclassical Synthesis - Shortcomings No explicit micro-foundations; No discussion of the equilibrium and welfare issues; No explicit treatment of expectations; Comparative-static approach – no full-fledged dynamics.  In the coming lectures, we will be discussing the CA determination in equilibrium, in dynamic models with rational economic agents, starting with a simple 2- period model.

2-Period Model: Assumptions Economy exists for two periods only; Single tradable good (real ER always equal to 1); Prices fully flexible; Income of a representative household Y 1, Y 2 falls down from heaven; The good is non-storable (no investment); No assets or debt at the beginning of period 1.

Closed Economy In equilibrium, a closed economy must consume its income; If Y 1 << Y 2, everyone wants to borrow  interest rate jumps up to a very high level (see Figure). Slope: (1+r)

Closed Economy - example The desire to smooth consumption is very strong, the uneven pattern of income drives interest rates incredibly high.

Small Open Economy Can borrow with no limits at world interest rate r*; This helps smooth the consumption and increase welfare; Debt must be repaid by a surplus in period 2.

Open Economy - solution Consumption depends on lifetime income; Impact of r*: (i) substitution effect (1+r*) 1/  ; (ii) income effect (1+r*) -1 ; (iii) wealth effect.

Open Economy - example

Introducing Government Consumption Government consumption financed by lump-sum taxes, must respect the inter-temporal budget constraint; Gov‘t faces the same real interest rates as the individuals; Households maximize their utility:

Government Consumption If the government consumption is high in period 1 (the picture assumes G 2 =0), country borrows abroad; The borrowing improves welfare; Ricardian equivalence holds.

Open Economy with Gov‘t – solution (i) Government consumption decreases the life-time wealth available for private consumption. The propensity to consume does not change.

Open Economy with Gov‘t – solution (ii)

Gov‘t Consumption - example

Summary In the two period model with perfect international financial markets, a current account deficit or surplus is not a sign of disequilibrium. It helps smoothing the consumption over time when there are income shocks, as well as shocks to the government consumption. By doing so, interteporal trade increases the welfare (like almost any other kind of voluntary trade between economic agents).