International macroeconomics

International Macroeconomics 1 Stephanie Schmitt-Groh´e 2 Mart´ın Uribe 3 January 26, 2014 1 The seeds for this manuscript were lecture notes taken by Alberto Ramos in a course on International Finance that Mike Woodford taught at the University of Chicago in the Winter of 1994. 2 Columbia University. E-mail: stephanie.schmittgrohe@columbia.edu. 3 Columbia University. E-mail: martin.uribe@columbia.edu. ii Contents 1 Global Imbalances 1 1.1 Balance-of-Payments Accounting . . . . . . . . . . . . . . . . 1 1.2 The Current Account . . . . . . . . . . . . . . . . . . . . . . 5 1.3 The Current Account and the Net International Investment Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 1.4 Valuation Changes and the Net International Investment Po- sition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 1.5 The Negative-NIIP-Positive-NII Paradox: Dark Matter? . . 21 1.5.1 Dark Matter . . . . . . . . . . . . . . . . . . . . . . . 23 1.5.2 Return Differentials . . . . . . . . . . . . . . . . . . . 24 1.6 Who Lends and Who Borrows Around the World? . . . . . . 27 1.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 2 Current Account Sustainability 37 2.1 Can a Country Run a Perpetual Trade Balance Deficit ? . . . 37 2.2 Can a Country Run a Perpetual Current Acco unt Deficit? . 41 2.3 Savings, Investment, and the Current Account . . . . . . . . 43 iii iv CONTENTS 2.3.1 Current Account Deficits As Declines in the Net In- ternational Investment Position . . . . . . . . . . . . . 43 2.3.2 Current Account Deficits As Reflections of Trade Deficits 44 2.3.3 The Current Account As The Gap Between Savings and Investment . . . . . . . . . . . . . . . . . . . . . . 44 2.3.4 The Current Account As the Gap Between Nati onal Income and Domestic Abs orption . . . . . . . . . . . . 46 2.4 Appendix: Perpetual Trade-Balance and Current-Account Deficits in Infinite-Horizon Economies . . . . . . . . . . . . . 48 2.5 E xercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 3 A Theory of Current Account Determination 55 3.1 A Small Open Economy . . . . . . . . . . . . . . . . . . . . . 55 3.1.1 Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 64 3.2 Temporary Versus Permanent Output Shocks . . . . . . . . . 68 3.2.1 Temporary Output Shocks . . . . . . . . . . . . . . . 70 3.2.2 Permanent Output Sho cks . . . . . . . . . . . . . . . . 72 3.3 Terms-of-Trade Shocks . . . . . . . . . . . . . . . . . . . . . 74 3.4 World Interest Rate Shocks . . . . . . . . . . . . . . . . . . . 76 3.5 An Economy with Logarit hmic Preferences . . . . . . . . . . 77 3.6 Capital Controls . . . . . . . . . . . . . . . . . . . . . . . . . 81 3.7 E xercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 4 Uncertainty and the Current Account 89 4.1 The Great Moderation . . . . . . . . . . . . . . . . . . . . . . 90 CONTENTS v 4.1.1 The Grea t Moderation And The Emergence of Trade Imbalances . . . . . . . . . . . . . . . . . . . . . . . . 92 4.2 A Model With Uncertai nty . . . . . . . . . . . . . . . . . . . 93 4.3 The Return of Uncertainty: The Great Contraction And The Current Account . . . . . . . . . . . . . . . . . . . . . . . . . 98 4.4 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 0 5 Current Account Determ ination in a Production Economy 103 5.1 A production economy . . . . . . . . . . . . . . . . . . . . . . 104 5.1.1 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 5.1.2 Households . . . . . . . . . . . . . . . . . . . . . . . . 109 5.1.3 Equilibrium in a closed economy . . . . . . . . . . . . 111 5.1.4 Equilibrium in an open economy . . . . . . . . . . . . 117 5.2 Current account adjustment to output and world-interest-rate shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 5.2.1 A temporary output shock . . . . . . . . . . . . . . . 122 5.2.2 A world-interest-rate shock . . . . . . . . . . . . . . . 124 5.3 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 6 6 Ex ternal Adjustment in Small and Large Economies 131 6.1 An investment surge . . . . . . . . . . . . . . . . . . . . . . . 136 6.2 Country risk premium . . . . . . . . . . . . . . . . . . . . . . 137 6.3 Large open economy . . . . . . . . . . . . . . . . . . . . . . . 139 6.4 The Global Saving Glut, the U.S. Current Account Deficit, and the Great Recession of 2007 . . . . . . . . . . . . . . . . 141 6.5 Optimal Ca pital Controls in a Two-Country Model . . . . . . 145 vi CONTENTS 6.5.1 Market Clearing in World Capital Markets . . . . . . 151 6.5.2 Equilibrium Under Free Capital Mo bility . . . . . . . 152 6.5.3 Equilibrium when country C imposes capital controls 154 6.6 E xercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 7 Twin Deficits: Fiscal Deficits and Current Account I mbal- ances 165 7.1 Twin Deficits i n the Uni ted States . . . . . . . . . . . . . . . 166 7.2 Testable Implicat ions of the Twin Deficit Hypothesis . . . . . 168 7.3 The government sector in the open economy . . . . . . . . . 17 5 7.4 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . . . 180 7.4.1 Then what was it? . . . . . . . . . . . . . . . . . . . . 184 7.5 Government Spending and Current Account Deficits . . . . . 184 7.6 Failure of Ri cardian Equivalence . . . . . . . . . . . . . . . . 187 7.6.1 Borrowing Constraints . . . . . . . . . . . . . . . . . . 187 7.6.2 Intergenerational E ffects . . . . . . . . . . . . . . . . . 190 7.6.3 Distortionary Taxation . . . . . . . . . . . . . . . . . . 191 7.7 E xercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 8 International Capital Market Integration 195 8.1 Measuring the degree of capital mobility: (I) Saving-Investment correlations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196 8.2 Measuring capital mobility: (II) Interest rate differentials . . 204 8.2.1 Covered interest rate parity . . . . . . . . . . . . . . . 205 8.2.2 Real interest rate differentials and capital market in- tegration . . . . . . . . . . . . . . . . . . . . . . . . . 212 CONTENTS vii 8.2.3 Exchang e Risk Premium (f −s e ) . . . . . . . . . . . . 216 8.2.4 Expected Real Depreciation, s e −s + π ∗e −π e . . . . 21 7 9 Determinants of the Real Exchange Rate 221 9.1 The Real Exchange Rate and Purchasing Power Parity . . . . 221 9.2 Productivity Differentials and Real Exchange Rates: The Balassa-Samuelson Model . . . . . . . . . . . . . . . . . . . . 230 9.2.1 Application: The Real Exchange Rate and Labor Pro- ductivity: 1970-1993 . . . . . . . . . . . . . . . . . . . 236 9.2.2 Application: Deviations from PPP observed between rich and poo r countr ies . . . . . . . . . . . . . . . . . 238 9.3 Trade Barri ers and Real E xchange Rates . . . . . . . . . . . . 240 10 Changes in Aggregate Spending and the Real Exchange Rate 243 10.1 The production possibility frontier . . . . . . . . . . . . . . . 244 10.2 The income expansion path . . . . . . . . . . . . . . . . . . . 249 10.3 Partial equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 255 10.4 General equi librium . . . . . . . . . . . . . . . . . . . . . . . 2 60 10.5 Wealth sho cks and the real exchange rate . . . . . . . . . . . 267 10.6 World interest rate shocks . . . . . . . . . . . . . . . . . . . . 269 10.7 Terms-of-trade shock s . . . . . . . . . . . . . . . . . . . . . . 2 71 10.8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275 11 The Macroeconomics of External Debt 281 11.1 The debt cris is of developing countries of the 1980s . . . . . . 28 1 viii CONTENTS 11.2 The resurgence of capital inflows to developing countries in the 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288 11.3 The Debt Burden . . . . . . . . . . . . . . . . . . . . . . . . . 291 11.4 Debt Reduction Schemes . . . . . . . . . . . . . . . . . . . . . 294 11.4.1 Unilatera l Debt For giveness . . . . . . . . . . . . . . . 294 11.4.2 Debt Overhang . . . . . . . . . . . . . . . . . . . . . . 296 11.4.3 The Free Rider Problem In Debt Forgiveness . . . . . 299 11.4.4 Third-party debt buy-backs . . . . . . . . . . . . . . . 300 11.4.5 Debt swaps . . . . . . . . . . . . . . . . . . . . . . . . 301 11.5 Exerci s es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305 12 Monetary Policy and Nominal Exchange Rate Determina- tion 307 12.1 The quantity theory of money . . . . . . . . . . . . . . . . . . 308 12.1.1 AFloating (or Flexible) Exchange Rate Regime . . . . 310 12.1.2 Fixed Exchange Rate Regime . . . . . . . . . . . . . . 31 1 12.2 Fiscal deficits, inflation, and the exchange rate . . . . . . . . 312 12.2.1 The Demand For M oney . . . . . . . . . . . . . . . . . 313 12.2.2 Purchasing p ower parity (PPP) . . . . . . . . . . . . . 314 12.2.3 The interest parity condition . . . . . . . . . . . . . . 315 12.2.4 The government budget constraint . . . . . . . . . . . 316 12.3 A fixed exchange rate regi me . . . . . . . . . . . . . . . . . . 318 12.3.1 Fiscal deficits and the sustainability of currency pegs . 319 12.4 A constant -money-grow th-rate regime . . . . . . . . . . . . . 322 12.5 The Inflation Tax . . . . . . . . . . . . . . . . . . . . . . . . . 325 CONTENTS ix 12.5.1 The Inflation Tax Laffer C urve . . . . . . . . . . . . . 327 12.5.2 Inflationary finance . . . . . . . . . . . . . . . . . . . . 327 12.5.3 Money growth and inflation in a growing economy . . 332 12.6 Balance-of-payments crises . . . . . . . . . . . . . . . . . . . 334 12.7 Appendix: A dynamic optimizing model of the demand for money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342 x CONTENTS [...]... change for two reasons One is deficits or surpluses in the current account, which imply, respectively, International Macroeconomics, Chapter 1 13 net international purchases or sales of assets The other source of changes in the NIIP is changes in the price of the financial instruments that compose the country’s international asset and liability positions So we have that ∆N IIP = CA + valuation changes, where... exchange rate of 1 dollars per euro to 175 dollar The country’s international liabilities do International Macroeconomics, Chapter 1 17 not change in value, because they do not contain shares in Fiat The NIIP then turns positive again and equals 175 − 80 = 95 dollars This shows that an increase in foreign stock prices can improve a country’s net international investment position Finally, suppose that, because... changes in a country’s net international investment position The term Net International Investment Position (NIIP) is used to refer to a country’s net foreign wealth, that is, the difference between the value of foreign assets owned by the country’s residents and the value of the country’s assets owned by foreigners NIIP is a stock while the current account (CA) is a flow The net international investment... −2 −3 −4 −5 −6 1960 1965 1970 1975 1980 Source: http://www.bea.gov 1985 Year 1990 1995 2000 2005 2010 7 International Macroeconomics, Chapter 1 Table 1.1: U.S Current Account, 2012 Item Current Account Trade Balance Merchandise Trade Balance Services Balance Income Balance Net Investment Income Net International Compensation to Employees Net Unilateral Transfers Private Remittances U.S Government Transfers... peripheral European countries, have experienced sudden reversals in international capital flows that were followed by costly financial and economic crises Indeed the 2008 financial meltdown in the United States has brought this issue to the fore 1.4 Valuation Changes and the Net International Investment Position We saw earlier that a country’s net international investment position can change either because of... 100 The country’s NIIP is given by the difference between its international asset position, A, and its international liability position, L, or N IIP = A−L = 100−80 = 20 Suppose now that the euro suffers a significant depreciation, losing half of its value relative to the dollar The new exchange rate is 1 dollar per euro Since the country’s international asset position is denominated in euros, its value... Net International Investment Position One reason why the concept of Current Account Balance is economically important is that it reflects a country’s net borrowing needs For example, as we saw earlier, in 2012 the United States ran a current account deficit of 475 billion dollars To pay for this deficit, the country must have either reduced part of its international asset position or increased its international. .. allowed the United States to run unprecedented current account deficits without a concomitant deterioration of its net international investment po4 See Gian Maria Milesi-Ferretti, “A $2 Trillion Question,” VOX, January 28, 2009, available online at http://www.voxeu.org International Macroeconomics, Chapter 1 21 sition, came to an abrupt end in 2008 Look at the dot corresponding to 2008 in figure 1.4... there is no dark matter, but that the United States earns a higher interest rate on its foreign asset holdings than foreigners earn International Macroeconomics, Chapter 1 25 on their U.S asset holdings The rationale behind this explanation is the observation that the U.S international assets and liabilities are composed of different types of financial instruments Specifically, the data show that foreign... price changes (or valuation changes) in the next section In the absence of valuation changes, the level of the current account must equal the change in the net international investment position Figure 1.3 shows the U.S current account balance and net international investment position since 1976 Notice that the U.S NIIP was positive at the beginning of the sample In the early 1980s a long sequence of current . keeps record of sales of assets t o foreigners and purchases of assets located abroad. Thus, the financial account measures changes i n a country s net f oreign asset position. Sales of assets to. consist of: i. U .S. purchases and s ales of foreign securities, U .S. bank lend- ing to foreigners, and U .S. direct investment abroad. (b) Foreign-ow ned assets held in the United States consist. reign assistance (grants) for which no repayment is expected. 2. Financial Account: Difference between sales of assets to for eigners and purchases of assets from foreigners. (a) U .S owned assets abroad