Current Account

Metzler Diagram

Savings and Investment ScheduleIn a closed economy, current account is zero and interest rates sets savings equal to investment.

S,I

r

SP + ( T-G)

IrA

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

S,I

r

SP + ( T-G)

IrA

rW

Current Account Deficit

S,I

r

SP + ( T-G)

IrA

rW

Current Account Surplus

S,I

r

SP + ( T-G)

IrA

rW

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

S,I

r

SP + ( T-G)

IrArW

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

S,I

r

SP + ( T-G)

IrArW

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

Examples1. Government increases spending without increasing

taxes. Consumers do not adjust consumption.2. 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:1. 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.

2. 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.

S,I

r [SP + ( T-G)]W

IW

rW

rA

[SP + ( T-G)]W’

Rise in world real interest rate will change domestic current account

S,I

r SP + ( T-G)

I

rW

rW’

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

Budget and Current Account Deficits

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

% o

f G

DP

CA/Y

(T-G)/Y

Is today’s current account imbalance due to US budget deficits? One counterargument is that

current real interest rates are low. Real Interest Rate -USA

-1.00

0.00

1.00

2.00

3.00

4.00

5.00F

eb-9

7

Aug

-97

Feb

-98

Aug

-98

Feb

-99

Aug

-99

Feb

-00

Aug

-00

Feb

-01

Aug

-01

Feb

-02

Aug

-02

Feb

-03

Aug

-03

Feb

-04

Aug

-04

Feb

-05

% VALUE

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:1. High savings rates due to demographic shifts will

decline.2. Investment will also decline. If investment is

currently dropping more than saving, current account will expand?

Current Account Surplus

S,I

r

SP + ( T-G)

IrW

Summary: Macroeconomics from Three Perspectives1. Long-term: Considered the determinants of

economic growth and GDP per person.2. Short-term: Examined the behavior of demand,

interest rates and monetary policy, and exchange rates at business cycle frequency.

3. 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.