Eco 344----Slide 3
After Midterm Exam 2
Chapter 6:
Gain from Financial Globalization
• Why does individual person saves or borrows?
• Essentially, saving in good times and
borrowing in bad times allow person to
smooth consumption
• One gain of financial globalization is to
allowing a country to smooth consumption
Borrowing Constraint
• A person must pay off his debt before he dies
• This is called No-Ponzi Game condition
• For a country, No-Ponzi game condition
guarantees that the country must service its
debt and must not allow debt to roll over and
grow without limit
• Long-Run Budget Constraint (LRBC) is the
mathematical formulation of No-Ponzi game
condition
Present Value
• Suppose you will earn 1 dollar one year later
• The future value of this earning is 1 dollar
• The present value of this earning is 1/(1+i)
dollar, where i denotes nominal interest rate
• In general, the present value (PV) of X dollars
earned in Q periods later can be solved from
the equation:
PV(1+i)Q =X
Remarks
• Future value and present value differ because
money can earn interest
• Money earns interest because people need to
be compensated for delaying consumption
Warm Up
• Wealth (W) is Stock
• Borrowing (TB<0), Lending (TB>0), capital
gains and interest payment (𝑟 ∗ W) are Flows
• Change of stock is flow
Two-Period (N=0, 1) LRBC
• 𝑊0 = 𝑇𝐵0 + (1 + 𝑟 ∗ )𝑊−1
• 0 = 𝑊1 = 𝑇𝐵1 + (1 + 𝑟 ∗ )𝑊0 (No PonziGame)
• 0 = 𝑇𝐵1 + 1 + 𝑟 ∗ 𝑇𝐵0 + (1 + 𝑟 ∗ )2 𝑊−1
(Future Value Form of LRBC)
∗
• −(1 + 𝑟 )𝑊−1 = 𝑇𝐵0 +
Form of LRBC)
𝑇𝐵1
1+𝑟 ∗
(Present Value
Remarks
• Positive initial wealth (𝑊−1 >0) allows a
country to borrow (TB<0) in both periods
• The total amount of borrowing is limited, in
the PV sense.
• Given zero initial wealth, TB must have
opposite signs in the two periods
General (N>1) LRBC
• The minus PV of initial wealth must equal the
PV of trade balance, see equation (6-1)
• Equivalently, the PV of GDP (income) plus the
PV of initial wealth must equal the PV of GNE
(expenditure), see equation (6-3)
Application: Favorable Situation of US
• How to modify LRBC for US
• Why is it a bad idea to default US debt?
• Why is it important to maintain the status of
reserve currency for US dollar?
• Why does the government want to protect
Wall Street?
Application: Difficult Situations of
Emerging Markets
• How to modify LRBC for Thailand
• Why does emerging-market country want to
keep foreign reserve?
• Why does emerging-market country hate
Soros?
US Debt
• http://www.bbc.co.uk/news/business14760684
• http://www.bbc.co.uk/news/business14204527
A Model of Smoothing Consumption
Monetary Policy
• Monetary policy is effective if it can change
the interest rate and if the total demand
responds to the change in the interest rate.
• There are three scenarios in which monetary
policy becomes ineffective
Scenario One: Irresponsive Demand
• Vertical IS curve
• Expansionary monetary policy can cause
interest rate to fall, but total demand is
irresponsive to falling interest rate.
• This can happen when firms and individuals
have very bad expectation for future economy.
Scenario Two: Liquidity Trap
• Liquidity trap occurs when nominal interest
rate equals zero
• Increasing money supply cannot cause
interest rate to go down further
• Real interest rate can be high due to deflation
• Investment and consumption remain low due
to high real interest rate
• http://en.wikipedia.org/wiki/Liquidity_trap
Scenario Three: Fixed Exchange Rate
• Increasing money supply causes interest rate
goes down, and exchange rate to go up
• To maintain peg, central bank intervenes the FX
market by buying domestic currency and sell
foreign reserve
• The intervene causes money supply to go back to
its original level
• So fixed exchange rate plus capital mobility forces
a country to give up autonomous monetary policy
(Trilemma).
Fiscal Policy
• Increasing government expenditure shifts IS
line up, causing interest rate and output to
rise
• Rising interest rate crowds out investment and
export.
• Crowding out can be big if LM line is steep
Ricardian Equivalence
• Fiscal policy becomes ineffective if the rising
government expenditure is totally offset by
the falling personal consumption. People save
more (and consume less) because they expect
later government will rise tax to pay the
expenditure. This is called Ricardian
Equivalence.
Effective Fiscal Policy
• Fiscal policy can be very effective in two
scenarios:
• (1) Liquidity Trap (there is no crowding out
due to flat LM line).
• (2) Fixed exchange rate (the money supply
automatically reinforces the effect of rising
government expenditure)
Discuss: How to boost US economy
• How about expansionary monetary policy?
• How about expansionary fiscal policy?
• What kind of difficulties are we facing?