8/12/2019 Lecture 2 Extension of Basic Model to 2 Country Setting

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Topic 1

The inter-temporal approach tothe current account (applications)

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A two country world

• In the simple 2 period model, we assumed thatthe real interest rate was exogenous – the islandeconomy was small.

• Once we allow for a world comprising two largeblocs (“US” and “China”), the real interest ratecan be determined endogenously.

• Fisher “separation” no longer holds. Shiftingconsumption preferences can change the interestrate and, in turn, investment.

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• The optimisation problem for each country is

• And the Euler equation is

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• Next, specify production functions, utility

functions and the intertemporal budget

constraint for each country

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• Note that the world as a whole is a closedeconomy, ie CAt + CA*t = 0.

• And the higher is the intertemporal elasticityof substitution, the more willing we are to giveup present consumption in exchange for

future consumption if conditions change.

• See O&R for the solution of C1

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• Changing the interest rate has complex effects onconsumption (savings) behavior – Substitution effect

 – Income effect

 – Wealth effect

• In a nutshell, if r increases it is good news for lendersand bad news for borrowers – income effect

•Substitution effect implies we reallocate resources tothe good that is relatively cheap.

• A rise in r changes the discounting of period 2 output(Y2/1+r) – lowering lifetime wealth

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Finding the world interest rate

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Productivity shock in ‘advanced’

country

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Savings glut?

• Bernanke suggests that global imbalances in currentaccounts are driven by events largely outside US.

 – Strong savings motives of rich countries with ageing

populations – Asian countries becoming net exporters of capital post

1997, precautionary building of reserves

 – Sharp rises in oil prices leading to CA surpluses in oilexporters in Middle East, Russia

• Model implies real interest rates will be low if desiredsaving > desired investment

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Some puzzles

• Puzzle 1: Why does capital flow in the “wrong”direction? Emerging market economies arelending to the advanced countries.

• Bernanke – difficult investment climates in theEMEs and a lack of financial liberalization.

• We will visit this issue in the next couple oflectures

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• Puzzle 2: Is capital less mobile than we presume (Feldstein-Horioka)?

• The basic model assumes capital is perfectly mobile and a country’ssaving will seek out the most productive investment worldwide. Sosavings and investment will diverge over time

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• Some countries (especially EMEs and Australiapre 1983) tried to target the CA.

• If firms face credit constraints and cannot borrowfreely, then their investment will depend on theirretained earnings (i.e. their savings).

• Plenty of unresolved puzzles in internationalmacroeconomics!!