External Adjustment in Small
and Large Economies
Roberto Chang
Econ 336
April 2013
• The last decade witnessed increased
global imbalances, especially prior to the
global financial crisis.
• Also, a fall in world interest rates
USA: Current Account (% of GDP)
0.01
0
1989
1991
1993
1995
1997
1999
-0.01
-0.02
-0.03
-0.04
-0.05
-0.06
-0.07
Source: Bureau of Economic Analysis (BEA)
2001
2003
2005
2007
Real Interest Rates, 1999-2006
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
Ja
n99
Ju
l-9
9
Ja
n00
Ju
l-0
0
Ja
n01
Ju
l-0
1
Ja
n02
Ju
l-0
2
Ja
n03
Ju
l-0
3
Ja
n04
Ju
l-0
4
Ja
n05
Ju
l-0
5
Ja
n06
Ju
l-0
6
0.00
10-Year 3-7/8% Treasury Inflation-Indexed Note. Source: FRED, Federal Reserve Bank of St. Louis
Source: Lane and Milesi Ferreti 2006
Source: Lane and Milesi Ferreti 2006
• We can use the theory discussed in class
to interpret these developments.
• We end up with a theory of world
equilibrium.
• Main reference: SU, ch. 4
• The starting point is the investment
schedule and the savings schedule, which
we derived already.
The Savings Function
Interest
Rate
S
r*
S
S*
Savings
Interest
Rate
An increase in savings.
This may be due to
higher Y(1).
S
S
S’
S’
Savings
The Investment Function
Interest
Rate
I
r*
I
I*
Investment
An increase in investment,
May be due to an increase in the future MPK
Interest
Rate
I’
I
r*
I’
I
I*
I**
Investment
• Recall that the current account is equal to
savings minus investment. This suggests
putting the two schedules together will
give us the current account.
Interest
Rate
Savings and Investment
I
S
S
I
S, I
Interest
Rate
Savings and Investment
I
S
If the world interest rate
is r*, savings are S* and
investment I*
r*
S
I
S*
I*
S, I
Interest
Rate
Savings and Investment
I
S
The current account is
CA* = S* - I* (a deficit)
r*
S
I
S*
I*
CA Deficit
S, I
Interest
Rate
Savings and Investment
I
S
r**
If the world interest rate
increases to r**,
savings increase to S**
and investment
falls to I**
r*
S
I
S* I**
S** I*
S, I
Interest
Rate
Savings and Investment
I
S
r**
The current account
is now in surplus,
Since CA** = S** - I**
r*
S
I
S* I**
S** I*
CA Surplus
S, I
Interest Rate
I
S
S
I
S, I
Interest Rate
The Current Account Diagram
Interest Rate
CA
I
S
S
I
S, I
0
CA
=
S-I
If the world interest rate is rA, the CA is zero
CA
I
S
rA
S
I
S, I
0
CA
If the world interest rate is r*, the CA is in deficit
CA
I
S
rA
r*
S
I
S, I
0
CA
If the world interest rate is r*, the CA is in deficit
CA
I
S
rA
r*
S
I
S, I
0
CA
If the world interest rate is r**, the CA is in surplus
CA
I
S
r**
rA
S
I
S, I
0
CA
• Now we can ask the question: what can
cause a CA deficit? An increase in
savings? An increase in investment?
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S
S
I
S, I
0
CA
=
S-I
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S’
S
S
S’
I
S, I
0
CA
=
S-I
An Increase in Savings
Interest Rate
Interest Rate
CA
I
S’
S
S
S’
CA’
I
S, I
0
CA
=
S-I
The CA improves, given r*
Interest Rate
Interest Rate
CA
I
S’
S
CA’
r*
S
S’
I
S, I
0
CA
=
S-I
An Increase in Investment
Interest Rate
Interest Rate
CA
I
S
S
I
S, I
0
CA
=
S-I
An Increase in Investment
Interest Rate
Interest Rate
CA
I
S
S
I
S, I
0
CA
=
S-I
The CA deteriorates
Interest Rate
Interest Rate
CA
I
S
S
I
S, I
0
CA
=
S-I
• Note that some changes may cause both
the savings schedule and the investment
schedule to shift
• For example, an increase in the future
marginal productivity of capital causes
investment to increase and savings to fall.
(Savings fall because consumption today
must increase, in anticipation of future
income).
Interest Rate
An increase in the future
MPK (investment surge)
Interest Rate
CA
I
S
CA’’
S
I
S, I
0
CA
=
S-I
Interest Rate
If the world interest rate
Is r*, the deficit in current account
is CA’’, not CA’
CA
I
S
r*
S
I
S, I
CA’’
CA’
0
CA
=
S-I
World Equilibrium
• Assume two countries, US and rest of the
world (ROW).
• It will be useful to graph their CA
schedules in the same diagram.
The US CA schedule
CAUS
US Current
Account
The ROW CA schedule
CAROW
ROW Current
Account
• It is convenient, however, to measure the
ROW CA in the opposite direction (i.e.
positive to the left, negative to the right).
• We just “flip the axis.”
Interest rate
CAROW
-
+
The ROW CA schedule
Interest Rate
CAROW
+
-
The ROW CA schedule
Interest Rate
CAROW
r*
-
+
CA Surplus in ROW
The ROW CA schedule
Interest Rate
CAROW
r*
-
+
CA Deficit in ROW
• The world is in equilibrium if
CAUS + CAROW = 0
i.e. the US CA surplus or deficit is exactly matched
by a ROW deficit or surplus.
• The world interest rate adjusts to ensure this
equality
The US CA schedule
CAUS
US Current
Account
Add the ROW CA schedule
CAROW
ROW CA
CAUS
US Current
Account
The world interest rate
Is r*
CAUS
CAROW
r*
ROW CA
US Current
Account
The world interest rate
Is r*
CAUS
CAROW
r*
ROW CA
US CA deficit =
ROW CA surplus
US Current
Account
Application: The US CA Problem
• We can use this apparatus to examine two
possible explanations of the current US
CA situation: low savings in the US, and a
“savings glut” in the world (i.e. an increase
in savings in the ROW)
CAUS
CAROW
r*
ROW CA
US CA deficit =
ROW CA surplus
US Current
Account
A fall in the US savings rate
causes the CA schedule to move
to the left.
CAUS
CAROW
r*
ROW CA
US CA deficit =
ROW CA surplus
US Current
Account
The US CA deficit increases, and the world interest rate goes up
CAUS
CAROW
r**
r*
New US CA deficit
US Current
Account
CAUS
CAROW
r*
ROW CA
US CA deficit =
ROW CA surplus
US Current
Account
Increased savings in ROW move the CAROW schedule to the left
CAUS
CAROW
CAROW’
r*
ROW CA
US CA deficit =
ROW CA surplus
US Current
Account
The US CA deficit widens, and the interest rate falls.
CAUS
CAROW
CAROW’
r*
r**
ROW CA
The US CA deficit increases
US Current
Account
The Role of Fiscal Policy
• Suppose that the government must spend
an amount G(1) in period 1
• Assume, for now, that this is financed via
lump sum taxes T(1) = G(1) in period 1.
• Hence there is no fiscal deficit in period 1.
• Under these assumptions, the analysis is
exactly the same as if the household’s
income in period 1 had fallen by T(1) =
G(1).
Interest Rate
A Tax financed increase in G(1):
Effects at Home
Interest Rate
CAUS
I
S
S
I
S, I
0
CA
=
S-I
Interest Rate
A Tax financed increase in G(1):
Effects at Home
Interest Rate
CAUS
I
S
S
I
S, I
0
CA
=
S-I
Effect on World Equilibrium
New CAUS
CAROW
CAUS
r**
r*
New US CA deficit
US Current
Account
• One may ask the question: what would
happen if G(1) were financed by increased
government borrowing (i.e. a fiscal deficit)
rather than taxes in period 1?
• By definition, this would reduce national
savings, if other things were kept equal.
• However, other things are not equal.
• In particular, future taxes will have to
increase to service the national debt.
• Households will recognize this fact and
adjust (in this case, increase) their savings
correspondingly.
• In fact, in theory households will increase
savings so as to perfectly compensate for
the anticipated increase in taxes due to
the fiscal deficit.
• Hence private savings will increase exactly
by the amount of the fiscal deficit
• But then national savings do not change!!
Ricardian Equivalence
• Recap: a deficit financed increase in
government expenditure has the same
effects as a tax financed increase in G(1).
• In this sense, fiscal deficits are irrelevant
(once government expenditure is
accounted for).
• This is known as Ricardian Equivalence.
• Chapter 5 of Schmitt Grohe and Uribe’s
text discusses Ricardian Equivalence in
some detail. (Please read.)
Why Ricardian Equivalence May
Fail
• Households may face borrowing
constraints.
• The households that benefit from current
tax cuts may not be the ones that pay the
necessary future tax increases.
• Taxes may be not be lump sum.
The Economic Report of the
President, 2006
“In 2004 the United States ran a current account
deficit of $668 billion. This deficit meant the
United States imported more goods and services
than it exported. The counterpart to the U.S.
current account deficit was a U.S. capital
account surplus. This surplus meant that foreign
investors purchased more U.S. assets than U.S.
investors purchased in foreign assets, investing
more in the United States than the United States
invested abroad. “
Is this statement justified?
“The size and persistence of U.S. net capital
inflows reflects a number of U.S. economic
strengths (such as its high growth rate and
globally competitive economy) as well as
some shortcomings (such as its low rate of
domestic saving).”
“The recent rise in U.S. net capital inflows
between 2002 and 2004 in part reflects
global economic conditions (such as a
large increase in crude oil prices) as well
as policies (such as China’s exchange rate
policy) and weak growth in several other
large economies (such as Germany) that
led to greater net capital outflows from
these countries.”
Lessons for policy?
“Encouraging greater global balance of capital
flows would be helped by steps in several
countries. The United States should raise its
domestic saving rate. Europe and Japan should
improve their growth performance and become
more attractive investment destinations. Greater
exchange rate flexibility in Asia, including China,
and financial sector reforms could increase the
role of domestic demand in promoting that
region’s future growth.”
“In addition, the chapter makes two broader points. First,
global capital flows—the flow of saving and investment
among countries—should be analyzed from a global
perspective and not by considering U.S. economic
policies alone. Global capital flows are jointly determined
by the behavior of many countries. To understand why
the United States receives large net capital inflows
requires understanding why countries like Japan,
Germany, China, and Russia experience large net
capital outflows.
A second point is the need to distinguish between marketdriven and policy-driven capital flows. “
An answer (Roubini)
“Having the Chutzpah to title this deficit as a
capital account surplus and then go on for
the entire chapter to interpret all of the
global current account imbalances as a
matter of capital exporting countries (i.e.
countries who run current account
surpluses) and capital importing countries
(i.e. the few countries who run current
account deficits) is to confuse cause and
effect. ”
“…most of this "inflow" (call it more properly borrowing
binge) is coming on net not from willing private foreign
investors wanting to invest in U.S. assets but rather from
political agents, i.e. foreign central banks that are
oblivious to the low returns on U.S. Treasury bills and
bonds (and capital losses once the dollar falls) and are
lending cheaply to the U.S. Treasury. So much for the
rest of the world wanting to buy U.S. assets and we thus
generously running a current account deficit to
accommodate this portfolio demand for U.S. assets.”