International Economics: Intertemporal approach to the Current Account

Summary

This video explores the intertemporal approach to the current account, contrasting open and closed economies. It explains how countries can optimize their consumption by borrowing or lending internationally. The transcript covers key concepts like utility maximization, the role of interest rates, and the effects of output changes on the autarky interest rate. It also discusses the relationship between the current account, national savings, and investment, and how international trade impacts consumption decisions. Finally, the equilibrium in a global economy is analyzed, showing how savings and borrowing are balanced between countries.

Takeaways

• 😀 Intertemporal trade allows countries to exchange resources across time, influencing their current account balances through borrowing and lending.
• 😀 The intertemporal budget constraint relates current and future consumption, with the current account acting as the mechanism for balancing the timing of consumption.
• 😀 In a two-period endowment economy, the optimal consumption decisions depend on a country's subjective discount factor, beta, and the interest rate, r.
• 😀 The Euler equation describes the intertemporal marginal rate of substitution between current and future consumption, showing how consumption choices are influenced by the interest rate.
• 😀 In autarky (a closed economy), consumption must equal output, and the current account is balanced over time, with no borrowing or lending allowed.
• 😀 A country's current account in an open economy reflects its decision to borrow or lend internationally, depending on whether its domestic interest rate is higher or lower than the world rate.
• 😀 If the domestic interest rate is higher than the world interest rate, a country will have a current account deficit in the first period, importing present consumption and exporting future consumption.
• 😀 Conversely, if the domestic interest rate is lower than the world rate, the country will run a current account surplus, exporting present consumption and importing future consumption.
• 😀 The current account is related to national savings and investment decisions, where the account balance equals savings minus investment in an open economy.
• 😀 Changes in output levels influence the autarky interest rate and, subsequently, the current account, as increased savings or consumption affects the country’s borrowing or lending decisions.
• 😀 In a global context with two countries, the world interest rate is determined by the interaction of home and foreign savings, and it lies between the two countries' autarky interest rates.

Q & A

What is the intertemporal approach to the current account?

The intertemporal approach to the current account examines how countries trade resources across time by borrowing and lending. It links a country's consumption decisions across periods to its current account, showing how rearranging the timing of consumption can lead to gains from international lending and borrowing.

What role does the discount factor (β) play in the intertemporal model?

The discount factor (β) represents the consumer’s subjective impatience to consume. It discounts the utility from future consumption, meaning a higher β implies greater impatience for present consumption. β is used in the utility function to model intertemporal preferences.

How is the budget constraint in the two-period endowment model formulated?

The budget constraint in the two-period model is formulated as c1 + c2 / (1 + r) = y1 + y2 / (1 + r), where c1 and c2 represent consumption in the two periods, y1 and y2 are outputs in those periods, and r is the interest rate. This constraint ensures that the present value of consumption equals the present value of output.

What does the Euler equation in this model represent?

The Euler equation, u'(c1) = β * (1 + r) * u'(c2), represents the optimal trade-off between consumption in the two periods. It states that the marginal utility of consumption in the first period should equal the marginal utility of future consumption, adjusted for the interest rate and the discount factor.

What happens in an autarky (closed economy) in this model?

In an autarky, where borrowing and lending are not allowed, the country consumes what it produces in each period. The optimal consumption in each period is equal to output in that period (c1 = y1 and c2 = y2), and there is no intertemporal trade-off as no external borrowing or lending occurs.

How does the world interest rate impact the current account?

If the autarky interest rate is greater than the world interest rate, future consumption becomes relatively cheaper, leading to a current account deficit as the country borrows from the rest of the world. Conversely, if the autarky rate is lower than the world rate, the country will export present consumption and run a current account surplus.

What is the relationship between the domestic interest rate (r_a) and the world interest rate?

The domestic interest rate (r_a) is determined by the closed economy conditions, while the world interest rate (r) is set globally. If the domestic interest rate is higher than the world interest rate, a country will borrow from abroad, and if it is lower, the country will lend to the world.

How does the model explain the impact of output changes on the current account?

The model shows that changes in output affect the autarky interest rate, which in turn influences the current account. For example, if present output (y1) increases, the autarky interest rate falls, leading to a current account surplus. If future output (y2) increases, the interest rate rises, resulting in a current account deficit.

What is the significance of investment in the intertemporal model?

Investment plays a key role in financing capital accumulation. Countries borrow from abroad to finance investments when domestic savings are insufficient. This impacts the current account, as the balance now reflects the difference between national saving and investment.

How does the equilibrium in a two-region world economy determine the world interest rate?

In a two-region world economy, the equilibrium condition requires that global savings equal global investment. The world interest rate is determined by the balance of savings between the home and foreign countries. If savings in one country exceed domestic investment, that country will lend to the other, balancing the global saving-investment equation.