Current Account Metzler Diagram

Savings and Investment Schedule In a closed economy, current account is zero and interest rates sets savings equal to investment. r SP + ( T-G) rA I S,I

World Real Interest Rate A relatively small open economy will not affect world international financial markets. Take the world interest rate as given. If world interest rate is higher than autarky rate, then country would have a current account surplus. If world interest rate is lower than autarky rate, the the country would have a current account deficit.

Current Account Surplus SP + ( T-G) rW rA I S,I

Current Account Deficit SP + ( T-G) rA I rW S,I

Current Account Surplus SP + ( T-G) rW rA I S,I

What shifts the Current Account? Temporary shock to income may change savings profile. Example: Thailand and Sri Lanka are hit by Tsunami. This reduces current income from tourism, but since Tsunami’s happen only once per 500 years, this does not affect future marginal product of capital. Yt falls relative to future, savings falls.

Current Account Surplus SP + ( T-G) rW rA I S,I

What shifts the Current Account surplus? New technologies. Example: In the late 1990’s, US developed several new high-tech industries related to internet which offered a promise of high future productivity (which was largely born out) and income. Investment high and savings low

Current Account Surplus SP + ( T-G) rW rA I S,I

Twin deficits: What about changes in the budget deficit? Holding the response of private savings constant, an increase in the budget deficit will shift national savings Examples Government increases spending without increasing taxes. Consumers do not adjust consumption. Government cuts taxes without cutting G. Consumers spend all of their tax cut on consumption.

Ricardian Theory: Households are forward looking in re fiscal policy. If the government runs a deficit today, they must raise taxes in the future. High future taxes will reduce the present value of lifetime disposable income. Consumers should increase savings today. Examples: Government increases spending without increasing taxes, people will know that taxes will go up in the future to pay back debt, so they will cut back consumption. Government cuts taxes without cutting spending or spending plans. If people know that taxes must rise in the future to pay back debt, they will save any of their tax cut.

World Real Interest Rates Any given economy may take real interest rate as given. But the world is a closed economy, so world real interest rates will be set by world saving and investment. Changes in saving and investment in one country may affect current account in another country through interest rate.

Deficit of Savings in one country is large enough to shift world savings curve. [SP + ( T-G)]W’ r [SP + ( T-G)]W rA rW IW S,I

Rise in world real interest rate will change domestic current account SP + ( T-G) rW’ rW I S,I

In a number of episodes, US current account deficits have been associated with budget deficits

Is today’s current account imbalance due to US budget deficits Is today’s current account imbalance due to US budget deficits? One counterargument is that current real interest rates are low.

Demographics and Current Global Imbalances. In Japan and Korea, demographics suggest that share of population in the prime working years may be dropping over the next 2 decades. Implications: High savings rates due to demographic shifts will decline. Investment will also decline. If investment is currently dropping more than saving, current account will expand?

Current Account Surplus SP + ( T-G) rW I S,I

Summary: Macroeconomics from Three Perspectives Long-term: Considered the determinants of economic growth and GDP per person. Short-term: Examined the behavior of demand, interest rates and monetary policy, and exchange rates at business cycle frequency. Medium Term: Consider the fundamental exchange rate when prices can adjust and the adjustment of the current account to gaps between economic supply and demand.

Final Exam Date: Thursday May 19, 2005 Time: 12:30-3:30 Venue: LG1031 Subject Matter: Cumulative of all lectures. Approximately 70% on material after the midterm. Bring: Calculator, pens, pencils.