A Model of the Current Account

Costas Arkolakis
teaching assistant: Yijia Lu
Economics 407, Yale
January 2011
Model Assumptions
2 periods. A small open economy
Consumers:
Representative consumer
Period 1: allocates income to consumption or bonds (saving)
Consumption: C
1
, C
2
Bonds B
0
(initial savings), B
1
, B
2
. Given interest r
0
, r
1
Endoment Economy: Q
1
, Q
2
available to consumer
Equilibrium: World interest rate.
Impose no saving in last period B
2
= 0 (happens in equilibrium)
Normalize the price of the good to 1, in each period
Consumer
Budget Constraints
BC 1st period:
C
1
+B
1
B
0
= r
0
B
0
+Q
1
BC 2ns period:
C
2
+B
2
B
1
= r
1
B
1
+Q
2
No saving second period B
2
= 0
Combine the budget constraints and B
2
= 0
C
1
+
C
2
1 +r
1
= (1 +r
0
) B
0
+Q
1
+
Q
2
1 +r
1
Consumer
Utility U (C
1
, C
2
)
Consumer maximizes utility U (C
1
, C
2
) subject to (s.t.) budget
constraint
C
1
+
C
2
1 +r
1
= (1 +r
0
) B
0
+Q
1
+
Q
2
1 +r
1
If B
0
0, one choice is the basket C
1
= Q
1
, C
2
= Q
2
Consumer
[gure for BC and Indierence curves about here]
In equilibrium
U
1
(C
1
, C
2
)
U
2
(C
1
, C
2
)
= 1 +r
1
Equilibrium in the world market r
1
= r

Equilibrium
In equilibrium
U
1
(C
1
, C
2
)
U
2
(C
1
, C
2
)
= 1 +r
1
C
1
+
C
2
1 +r
1
= (1 +r
0
) B
0
+Q
1
+
Q
2
1 +r
1
r
1
= r

Equilibrium in the world market r

1
= r

Trade Balance
In equilibrium
(Q
1
C
1
)
(Q
2
C
2
)
1 +r

= (1 +r
0
) B
0
=)
TB
1

TB
2
1 +r

= (1 +r
0
) B
0
The Model will predict a behavior for the trade balance over the two
periods. If the country starts as debtor, B
0
> 0, it requires to repay debt
and thus TB
1
> 0 or TB
2
> 0 or both. (i.e. the rm has to be a net
exporter to repay the debt)
Current Account
We can rewrite the BC in terms of the current account
CA
1
= r
0
B
0
|{z}
net investment income
+ TB
1
|{z}
net exports
CA
2
= r

B
1
+TB
2
Thus,
TB
1

TB
2
1 +r

= (1 +r
0
) B
0
=)
(CA
1
r
0
B
0
)
(CA
2
r

B
1
)
1 +r

= (1 +r
0
) B
0
=)
(CA
1
)
CA
2
1 +r

+
r

B
1
1 +r

= B
0
=)
Current Account
Figure 2.3 about here
Current Account
Thus,
TB
1

TB
2
1 +r

= (1 +r
0
) B
0
=)
(CA
1
r
0
B
0
)
(CA
2
r

B
1
)
1 +r

= (1 +r
0
) B
0
=)
(CA
1
)
CA
2
1 +r

+
r

B
1
1 +r

= B
0
=)
But also CA
1
= B
1
B
0
, (change in net investmestment position
-accumulate debt or credit). so that
(1 +r

) (CA
1
) CA
2
+r

B
1
r

B
0
= B
0
=)
CA
1
CA
2
= B
0
Current Account Imbalances
Can a country run a perpertual CA decit
Use transversality condition,CA
1
CA
2
= B
0
Finite lifetime cannot happen.
Innite yes, make sure debt does not grow faster than your economy
Temporary vs Permanent Shocks
Temporary shock vs permanent shock
Temporary: parallel shift of BC in one period. Smooth consumption in
two periods (see FOCs)
CA decit in rst period. Surplus in second
Permanent. Consumption smoothing, CA might not be aected
Conclusion. Temporary shocks, larger swings in CA.
Twin Decits: Fiscal & Current Account Decits
Conjecture that an important determinant of CA is scal surplus (aects
government and thus total savings)
Correlation: scal decits various times coincide with CA decits
E.g. Reagan tax cuts caused large decits, same time CA turned negative
E.g.2 Obama stimulus plan, also at at time where decit is very large
Figure: US Saving and Investment in Percent of GNP. Source:
Schmitt-Groche and Uribe 2010
Ricardian Equivalence
Assume the existence of a Government
Government has assets B
g
0
,B
g
1
, B
g
2
and purchases goods G
1
, G
2
Faces constraints
G
1
+ (B
g
1
B
g
0
) = r
0
B
g
0
+T
1
G
2
+ (B
g
2
B
g
1
) = r
1
B
g
1
+T
2
LHS is spending. RHS is purchases. No Ponzi B
g
2
0 in equilibrium
B
g
2
= 0
Modeling the Government
Assume the existence of a Government
Government has assets B
g
0
,B
g
1
, B
g
2
and purchases goods G
1
, G
2
Faces constraints
G
1
+ (B
g
1
B
g
0
) = r
0
B
g
0
+T
1
G
2
+ (B
g
2
B
g
1
) = r
1
B
g
1
+T
2
LHS is spending. RHS is purchases. No Ponzi B
g
2
0 in equilibrium
B
g
2
= 0
Government and Household Budget Constraint
Comnbining Equations we have Gov. BC
G
1
+
G
2
1 +r
1
= (1 +r
0
) B
g
0
+T
1
+
T
2
1 +r
1
And household budget constraint
C
1
+T
1
+B
p
1
B
p
0
= r
0
B
p
0
+Q
1
C
2
+T
2
+B
p
2
B
p
1
= r
1
B
p
1
+Q
2
where household has to pay taxes and B
p
2
= 0.Combining the two
C
1
+
C
2
1 +r
1
= (1 +r
0
) (B
g
0
+B
p
0
) +Q
1
T
1
+
Q
2
T
2
1 +r
1
Combining All the Constraints
Combining the above equations
C
1
+G
1
+
C
2
+G
2
1 +r
1
= Q
1
+
Q
2
1 +r
1
LHS is present discounted value of domestic absorption
RHS is present discounted value of production
Notice that taxes are not there. So that the timing of the taxes may not
matter
As long as G
1
,G
2
are given and gov. intertemporal budget constaint is
satised.
Private and Government Saving
Assume G
1
, G
2
are given
Government saving
S
g
1
= r
0
B
g
0
+T
1
G
1
=) S
g
1
= T
1
Private saving
S
p
1
= Q
1
+r
0
B
p
0
T
1
+C
1
=) S
p
1
= T
1
Total saving is
S
1
= S
g
1
+S
p
1
Ricardian Equivalence
Total saving is
S
1
= S
g
1
+S
p
1
National savings is unaected by the timing of taxes: Ricardian
equivalence
Implies CA
1
= S
1
I
1
= 0
Changes in scal decit may induce oseting increases in private savings
(leaving total savings and CA constant)
Households internalize governments problem, adjust savings/consumption
rationally
If Ricardian Equivalence holds what is the cause of twin
decits?
Reagan time: Government savings plummeted but private savings did
not increase as much
National Savings and the CA plummeted
Some of the premises of the theory seem to not hold in this example
Maybe more government expenditure rather than less taxation
Ricardian equivalence does not hold!?
Maybe both
Discussion of the Lucas article
If all the countries have the same technologies
Cobb-Douglas prod function Y = Ak

l
1
, k :capital, l :labor
Income per capita =) y = A

k
l

Marginal product of capital =) r = A

k
l

1
=) r = A
1/
(y)
1

New investment should occur in poor countries

Quite the opposite, capital ows to/among rich countries
What is the explanation? Human capital? Externalities of human capital?