Chapter 15

International Trade in

Goods and Assets

Copyright © 2014 Pearson Education, Inc.

1-2© 2014 Pearson Education, Inc.

Chapter 15 Topics

• A two-period open economy model – the current account.

• Credit market imperfections and default.

• Production, investment, and the current account.

• Effects of changes in the world real interest rate, government spending, and productivity.

1-3© 2014 Pearson Education, Inc.

A Two-Period Small Open Economy Model

• Two periods – current period and future period.

• Representative consumer with exogenous current-period and future-period incomes.

• The SOE is a price-taker on world credit markets – the real interest rate is exogenous.

• The current account surplus here is equal to savings in the SOE, as there is no investment.

1-4© 2014 Pearson Education, Inc.

Lifetime Budget Constraint

The representative consumer’s lifetime budget constraint:

r

TT

r

CC

1

'

1

'

1-5© 2014 Pearson Education, Inc.

Government

The government’s intertemporal budget constraint:

r

TT

r

GG

1

'

1

'

1-6© 2014 Pearson Education, Inc.

Figure 15.1The Two-Period Small Open-Economy Model

1-7© 2014 Pearson Education, Inc.

Credit Market Imperfections and Default

• Problems with national indebtedness were important during the financial crisis and after, particularly in southern Europe.

• Use ideas on credit market frictions from Chapter 10 to address sovereign debt issues – model of limited commitment.

Figure 15.2Deviations from Trend in the Current Account Surplus and GDP

1-8© 2014 Pearson Education, Inc.

1-9© 2014 Pearson Education, Inc.

Budget Constraints for the Nation

• B = nation’s (private sector + government) debt to the world at beginning of current period.

• B’ = nation’s debt at beginning of future period• Current period budget constraint:

• Future period budget constraint:

'

1

BC G Y B

r

' ' ' 'C G B Y

1-10© 2014 Pearson Education, Inc.

Constraints for the Nation

• National present-value budget constraint:

• Limited commitment constraint:

• Or:

' ' '

1 1

C G YC G Y B

r r

'B v

1

vC G Y B

r

1-11© 2014 Pearson Education, Inc.

Figure 15.3Default is Chosen in the Current Period

1-12© 2014 Pearson Education, Inc.

Figure 15.4Default is not Chosen

1-13© 2014 Pearson Education, Inc.

Default

• When does a nation default on its debts?

• Default occurs when national debt is large, when the perceived future penalties from defaulting are small, and when the real interest rate is high.

1

vB

r

1-14© 2014 Pearson Education, Inc.

A Small Open Economy with Production and Investment

• Works the same as the real intertemporal model, except the real interest rate is determined on world credit markets, and given to the SOE.

• Current account surplus always adjusts so that the aggregate supply and aggregate demand curves intersect at the world real interest rate.

1-15© 2014 Pearson Education, Inc.

Figure 15.5A Small Open-Economy Model with Production and Investment

1-16© 2014 Pearson Education, Inc.

Figure 15.6An Increase in the World Real Interest Rate

1-17© 2014 Pearson Education, Inc.

Figure 15.7A Temporary Increase in Government Spending

1-18© 2014 Pearson Education, Inc.

Figure 15.8An Increase in Current Total Factor Productivity

1-19© 2014 Pearson Education, Inc.

Figure 15.9An Increase in Future Total Factor Productivity

Figure 15.10Investment as a Percentage of GDP

1-20© 2014 Pearson Education, Inc.

Figure 15.11Current Account Surplus as a Percentage of GDP

1-21© 2014 Pearson Education, Inc.