1. External Adjustment in Small and Large Economies Roberto Chang Econ 336 March 2012

2. As mentioned in class, the last decade witnessed increased global imbalances Also, a fall in world interest rates

3. USA: Current Account (% of GDP) Source: Bureau of Economic Analysis (BEA)

4. Real Interest Rates, 1999-2006 10-Year 3-7/8% Treasury Inflation-Indexed Note. Source: FRED, Federal Reserve Bank of St. Louis

5. Source: Lane and Milesi Ferreti 2006

7. We will use the theory discussed in class to interpret these developments. The starting point is the investment schedule and the savings schedule, which we derived already.

8. Savings r* S S The Savings Function Interest Rate S*

9. Savings Interest Rate S S An increase in savings. This may be due to higher Y(1). S’

10. Investment r* The Investment Function Interest Rate I* I I

11. Investment r* An increase in investment, May be due to an increase in the future MPK Interest Rate I* I I I’ I**

12. Recall that the current account is equal to savings minus investment. This suggests putting the two schedules together will give us the current account.

13. S, I S S Savings and Investment Interest Rate I I

14. S, I S S Savings and Investment Interest Rate I I r* S*I* If the world interest rate is r*, savings are S* and investment I*

15. S, I S S Savings and Investment Interest Rate I I r* S*I* The current account is CA* = S* - I* (a deficit) CA Deficit

16. S, I S S Savings and Investment Interest Rate I I r* S*I* If the world interest rate increases to r**, savings increase to S** and investment falls to I** r** I**S**

17. S, I S S Savings and Investment Interest Rate I I r* S*I* The current account is now in surplus, Since CA** = S** - I** r** I**S** CA Surplus

18. S, I Interest Rate S S I I

19. S, I S S I I CA = S - I The Current Account Diagram 0 Interest Rate

20. S, I S S I I 0CA rArA If the world interest rate is r A, the CA is zero

21. S, I S S I I 0CA rArA If the world interest rate is r*, the CA is in deficit r*

22. S, I S S I I 0CA rArA If the world interest rate is r*, the CA is in deficit r*

23. S, I S S I I 0CA rArA If the world interest rate is r**, the CA is in surplus r**

24. Now we can ask the question: what can cause a CA deficit? An increase in savings? An increase in investment?

25. S, I S S I I CA = S - I An Increase in Savings 0 Interest Rate

26. S, I S S I I CA = S - I An Increase in Savings 0 Interest Rate S’

27. S, I S S I I CA = S - I An Increase in Savings 0 Interest Rate S’ CA’

28. S, I S S I I CA = S - I The CA improves, given r* 0 Interest Rate S’ CA’ r*

29. S, I S S I I CA = S - I An Increase in Investment 0 Interest Rate

30. S, I S S I I CA = S - I An Increase in Investment 0 Interest Rate

31. S, I S S I I CA = S - I The CA deteriorates 0 Interest Rate

32. Note that some changes may cause both the savings schedule and the investment schedule to shift For example, an increase in the future marginal productivity of capital causes investment to increase and savings to fall. (Savings fall because consumption today must increase, in anticipation of future income).

33. S, I S S I I CA = S - I An increase in the future MPK (investment surge) 0 Interest Rate CA’’

34. S, I S S I I CA = S - I If the world interest rate Is r*, the deficit in current account is CA’’, not CA’ 0 Interest Rate r* CA’’ CA’

35. World Equilibrium

36. Assume two countries, US and rest of the world (ROW). It will be useful to graph their CA schedules in the same diagram.

37. The US CA schedule US Current Account CA US

38. The ROW CA schedule ROW Current Account CA ROW

39. It is convenient, however, to measure the ROW CA in the opposite direction (i.e. positive to the left, negative to the right). We just “flip the axis.”

40. + CA ROW - Interest rate

41. The ROW CA schedule + CA ROW - Interest Rate

42. The ROW CA schedule + CA ROW - Interest Rate r* CA Surplus in ROW

43. The ROW CA schedule + CA ROW - Interest Rate r* CA Deficit in ROW

44. The world is in equilibrium if CA US + CA ROW = 0 i.e. the US CA surplus or deficit is exactly matched by a ROW deficit or surplus. The world interest rate adjusts to ensure this equality

45. The US CA schedule US Current Account CA US

46. US Current Account CA US ROW CA CA ROW Add the ROW CA schedule

47. US Current Account CA US ROW CA CA ROW r* The world interest rate Is r*

48. US Current Account CA US ROW CA CA ROW r* The world interest rate Is r* US CA deficit = ROW CA surplus

49. Application: The US CA Problem We can use this apparatus to examine two possible explanations of the current US CA situation: low savings in the US, and a “savings glut” in the world (i.e. an increase in savings in the ROW)

50. US Current Account CA US ROW CA CA ROW r* US CA deficit = ROW CA surplus

51. US Current Account CA US ROW CA CA ROW r* US CA deficit = ROW CA surplus A fall in the US savings rate causes the CA schedule to move to the left.

52. US Current Account CA US CA ROW r** New US CA deficit The US CA deficit increases, and the world interest rate goes up r*

53. US Current Account CA US ROW CA CA ROW r* US CA deficit = ROW CA surplus

54. US Current Account CA US ROW CA CA ROW r* US CA deficit = ROW CA surplus Increased savings in ROW move the CA ROW schedule to the left CA ROW’

55. US Current Account CA US ROW CA CA ROW r* The US CA deficit increases The US CA deficit widens, and the interest rate falls. CA ROW’ r**

56. The Role of Fiscal Policy

57. Suppose that the government must spend an amount G(1) in period 1 Assume, for now, that this is financed via lump sum taxes T(1) = G(1) in period 1. Hence there is no fiscal deficit in period 1.

58. Under these assumptions, the analysis is exactly the same as if the household’s income in period 1 had fallen by T(1) = G(1).

59. S, I S S I I CA US CA = S - I A Tax financed increase in G(1): Effects at Home 0 Interest Rate

60. S, I S S I I CA US CA = S - I A Tax financed increase in G(1): Effects at Home 0 Interest Rate

61. US Current Account New CA US CA ROW r** New US CA deficit Effect on World Equilibrium r* CA US

62. One may ask the question: what would happen if G(1) were financed by increased government borrowing (i.e. a fiscal deficit) rather than taxes in period 1? By definition, this would reduce national savings, if other things were kept equal.

63. However, other things are not equal. In particular, future taxes will have to increase to service the national debt. Households will recognize this fact and adjust (in this case, increase) their savings correspondingly.

64. In fact, in theory households will increase savings so as to perfectly compensate for the anticipated increase in taxes due to the fiscal deficit. Hence private savings will increase exactly by the amount of the fiscal deficit But then national savings do not change!!

65. Ricardian Equivalence Recap: a deficit financed increase in government expenditure has the same effects as a tax financed increase in G(1). In this sense, fiscal deficits are irrelevant (once government expenditure is accounted for). This is known as Ricardian Equivalence.

66. Chapter 5 of Schmitt Grohe and Uribe’s text discusses Ricardian Equivalence in some detail. (Please read.)

67. Why Ricardian Equivalence May Fail Households may face borrowing constraints. The households that benefit from current tax cuts may not be the ones that pay the necessary future tax increases. Taxes may be not be lump sum.

68. The Economic Report of the President, 2006 “In 2004 the United States ran a current account deficit of $668 billion. This deficit meant the United States imported more goods and services than it exported. The counterpart to the U.S. current account deficit was a U.S. capital account surplus. This surplus meant that foreign investors purchased more U.S. assets than U.S. investors purchased in foreign assets, investing more in the United States than the United States invested abroad. “

69. Is this statement justified? “The size and persistence of U.S. net capital inflows reflects a number of U.S. economic strengths (such as its high growth rate and globally competitive economy) as well as some shortcomings (such as its low rate of domestic saving).”

70. “The recent rise in U.S. net capital inflows between 2002 and 2004 in part reflects global economic conditions (such as a large increase in crude oil prices) as well as policies (such as China’s exchange rate policy) and weak growth in several other large economies (such as Germany) that led to greater net capital outflows from these countries.”

71. Lessons for policy? “Encouraging greater global balance of capital flows would be helped by steps in several countries. The United States should raise its domestic saving rate. Europe and Japan should improve their growth performance and become more attractive investment destinations. Greater exchange rate flexibility in Asia, including China, and financial sector reforms could increase the role of domestic demand in promoting that region’s future growth.”

72. “In addition, the chapter makes two broader points. First, global capital flows—the flow of saving and investment among countries—should be analyzed from a global perspective and not by considering U.S. economic policies alone. Global capital flows are jointly determined by the behavior of many countries. To understand why the United States receives large net capital inflows requires understanding why countries like Japan, Germany, China, and Russia experience large net capital outflows. A second point is the need to distinguish between market- driven and policy-driven capital flows. “

73. An answer (Roubini) “Having the Chutzpah to title this deficit as a capital account surplus and then go on for the entire chapter to interpret all of the global current account imbalances as a matter of capital exporting countries (i.e. countries who run current account surpluses) and capital importing countries (i.e. the few countries who run current account deficits) is to confuse cause and effect. ”

74. “…most of this "inflow" (call it more properly borrowing binge) is coming on net not from willing private foreign investors wanting to invest in U.S. assets but rather from political agents, i.e. foreign central banks that are oblivious to the low returns on U.S. Treasury bills and bonds (and capital losses once the dollar falls) and are lending cheaply to the U.S. Treasury. So much for the rest of the world wanting to buy U.S. assets and we thus generously running a current account deficit to accommodate this portfolio demand for U.S. assets.”