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Unformatted text preview: A Complementary Handout on Global Imbalance Lemin Wu Feb., 2011 1 The Concept of Global Imbalance Imagine two villages trading with each other. One village runs a trade surplus; in return, the other village “pay” with IOU (I owe you). Goods and service flow and financial assets flow are two sides of the same coin. While the first village is producing extra goods and service to meet the demand of consumption of the second village, the financial sector of the latter is producing extra financial assets (loan, equity, bond) to meet the demand of investment of the former. 1.1 The promising future of Oakland Say, the two villages are Berkeley and Oakland. Spotted with construction sites every- where, Oakland has a great prospect of growth in the future. Q: What do you expect is most probably the direction of trade flow between Berkeley and Oakland? A: Berkeley is more likely to run a trade surplus. By exporting goods and service to Oakland, the Berkeleyans reap the claims to the future cash flow of the Oaklanders’ projects. Oaklanders, expecting increased productivity in the future, would be willing to borrow from Berkeleyans today to smooth their consumption over time. Why would they? This is where the result of the intertemporal approach to current account steps in. Remember that CA = Y t- ˜ Y t . A promising prospect suggests that Y t < ˜ Y t , so Oakland should run a current account deficit by borrowing from Berkeley. 1.2 But Oakland is OUTLANDISH! Irregularity happens. Suppose Oakland, instead of Berkeley, is running a trade surplus against its trade partner. What can be potential explanations? 1 1.2.1 Explanation 1: Oaklanders are saving too much. It could be that Oaklanders are saving so much that its ambitious investment is yet not big enough to exhaust the savings. So the Oaklanders are able to lend (net export) to the Berkeleyans. Doing so, the Oaklanders must have violated the above consumption smoothing rule. 1.2.2 Expectation 2: Wall Street is not in Oakland A second reason could be that Berkeley is endowed with a stock exchange and a solid banking system while Oakland is not. The Oakland residents would incur a high trans- action cost if they tried to find local investment opportunities without the help of profes-...
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