International Macroeconomics, Chapter 2
41
between the great moderation and the signicant trade balance deterioration
observed in the U.S. over the past twenty ve years. Panel (b) of gure 2.9
displays the ratio of the trade balance to GDP in the United St
25
International Macroeconomics, Chapter 2
Households choose C1 and C2 so as to maximize the utility function (2.5)
subject to the lifetime budget constraint (2.4). Figure 2.3 displays the lifeFigure 2.3: Equilibrium in the endowment economy
C2
A
Q
2
B
C
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out as a debtor of the rest of the world (B0 < 0), then it must run a trade
surplus in at least one period in order to repay its debt (T B1 > 0 or T B2 > 0
or both). Conversely, if at the beginning of period 1 the country
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Condition (2.6) is quite intuitive. Suppose that the consumer sacrices
one unit of consumption in period 1 and saves it by buying a bond paying the
interest rate r1 in period 2. Then his utility in period 1 falls by U1 (C
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where the function U is strictly increasing in both arguments. Figure 2.2
displays the households indierence curves. You should be familiar with
Figure 2.2: Indierence curves
C2
C1
the concept of indierence curves from in
23
International Macroeconomics, Chapter 2
Figure 2.1: The intertemporal budget constraint
C2
(1+r1)Q1+Q2
Q2
slope = (1+r1)
A
Q1
Q1+Q2/(1+r1)
C1
points on the budget constraint located southeast of point A correspond to
borrowing (or dissaving) in period
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Similarly, in period 2 the representative household faces a constraint stating
that consumption expenditure plus bond purchases must equal income:
C2 + B2 B1 = r1 B1 + Q2 ,
(2.2)
where C2 denotes consumption in period 2,
Chapter 2
A Theory of Current
Account Determination
In this chapter, we build a model of an open economy, that is, of an economy
that trades in goods and nancial assets with the rest of the world. We then
use that model to study the determinants of the tr
20
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It follows that
Bt
1 + r(1 )
=
t
(1 + r)
1+r
t
B0
which converges to zero as t becomes large because 1 + r > 1 + r(1 ).
Notice that under the assumed policy the trade balance evolves according
to
T Bt = r[1 + r(1 )]t B0 .
International Macroeconomics, Chapter 1
19
This expression states that the initial net foreign asset position of a country
must equal the present discounted value of the stream of current a future
expected trade decits. Clearly, if the initial foreign ass
30
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borrow from the rest of the world in period 1, that is, B1 0, then in
that period they can at most consume their endowment. Because under free
capital mobility C1 was greater than Q1 , the borrowing constraint will be
bin
29
International Macroeconomics, Chapter 2
2.2
Capital controls
Current account decits are often viewed as something bad for a country.
The idea behind this view is that by running a current account decit the
economy is living beyond its means. As a resul
27
International Macroeconomics, Chapter 2
If this condition is satised we will say that interest rate parity holds. The
country is assumed to be suciently small so that its savings decisions do
not aect the world interest rate. Because all households are
38
S. Schmitt-Groh and M. Uribe
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the trade balance and interests received on net foreign assets holdings, or
CA1 = r0 B0 + T B1 . Using the denition of Y and the fact that under free
nancial capital mobility the domestic interest rate must equal the worl
40
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Figure 2.9: The Great Moderation
(a) Per Capita U.S. GDP Growth 1948-2006
3
2
1
0
1
2
3
1950
1960
1970
1980
date
1990
2000
(b) U.S. Trade Balance To GDP Ratio 1948-2006
4
3
2
1
0
1
2
3
4
5
6
1950
1960
1970
Source: http:/w
International Macroeconomics, Chapter 2
2.5
39
The Great Moderation and the U.S. Trade
Balance
A number of resarchers have documented that the volatility of U.S. output declined signicantly starting in the early 1980s. This phenomenon
has become known as
34
S. Schmitt-Groh and M. Uribe
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periods. In general the decline in consumption should be expected to be
close to , implying that a permanent output shock has little consequences
on the trade balance or the current account.
Comparing the eects of tempora
31
International Macroeconomics, Chapter 2
this decline in output is temporary, in the sense that it is expected that next
year the banana crop will be back at its normal level. How would such a
shock aect consumption, the trade balance, and the current a
32
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the amount of the output decline, , thus leaving consumption in period 2
unchanged. However, if both C1 and C2 are normal goods (i.e., goods whose
consumption increases with income), the household will choose to smooth
co
International Macroeconomics, Chapter 2
35
following lifetime budget constraint:
C1 +
C2
T T 2 Q2
= (1 + r0 )B0 + T T1 Q1 +
1 + r1
1 + r1
Comparing this lifetime budget constraint with the one given in equation
(2.4), it is clear that terms of trade shock
33
International Macroeconomics, Chapter 2
2.3.2
Permanent Output Shocks
The pattern of adjustment to changes in income is quite dierent when the
income shock is of a more permanent nature.
To continue with the example of the drought in Ecuador, suppose t
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S. Schmitt-Groh and M. Uribe
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Figure 2.8: Adjustment to a world interest rate shock
C2
*
slope = (1+r +)
Q2
C2
A
B
B
C2
Q1 C
1
C1
C1
consumption point is given by point B, where the household is borrowing
in period 1. The new consumption allocation i
International Macroeconomics, Chapter 1
17
It then follows from equation (1.9) that the current account is equal to saving
minus investment,
CAt = St It
(1.10)
According to this relation, a decit in the current account occurs when
a countrys investment ex
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Now shift this expression one period forward to yield
B1 =
B2
T B2
.
1+r 1+r
Use this formula to eliminate B1 from equation (1.12) to obtain
B0 =
B2
T B1
T B2
.
2
(1 + r)
1 + r (1 + r)2
Shifting (1.12) two periods forward
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where T Bt denotes the trade balance in period t and r denotes the interest
rate.
The trade balance measures the dierence between a countrys exports
and imports of goods and non-nancial services. That is, letting Xt stand
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International Macroeconomics, Chapter 8
the marginal cost of labor, w. A similar relation arises from the protmaximizing behavior of rms in the nontraded sector:
PN FN (LN ) w = 0
Combining the above two rst-order conditions to eliminate w yields equa
Chapter 8
Changes in Aggregate
Spending and the Real
Exchange Rate: The TNT
Model
In the Balassa-Samuelson model studied in section 7.1, the production possibility frontier (PPF) is a straight line, which means that the slope of the
PPF is the same regard
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goods. In the absence of trade barriers, PPP must hold for both goods, that
is, the domestic prices of exportables and importables must be given by
PX = EPX
and
PM = EPM ,
where E denotes the nominal exchange rate dened
International Macroeconomics, Chapter 7
117
5.0, but Switzerlands real exchange rate vis-`-vis the dollar was only 0.6.
a
This means that in 2005 a basket of goods in Switzerland was about 8
(=5.0/0.6) times as expensive as in Bangladesh.
How can we expla
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growth. In the case of the Dollar/DM real exchange rate the observed real
appreciation of the dollar in the mid 1980s was not accompanied by a corresponding increase in relative productivity dierentials in favor of the U