CLASS #7: THE DETERMINANTS OF THE CURRENT ACCOUNT (ENDOWMENT ECONOMY)

• What determines Current Account deficits and surpluses?
• Are current account deficits sustainable for long periods of time?
• Twin deficits? What is the impact of fiscal policy on the Current Account?

THE CURRENT ACCOUNT IN A SMALL OPEN ECONOMY

The -small- country (private sector) has an income of Y1 and Y2 in periods 1 and 2 respectively, pays taxes T1 and T2 to its own government, whose spending is G1 and G2. The "representative" household has to decide how much to consume in period 1 and 2. Small economy: the interest rate r is given

$$max_{C1,C2} \ln (C1) + \beta \ln (C2)$$

subject to the constraint:

(1+r)(Y1+W-T1-C1)=C2-(Y2-T2)

and the government's budget constraint:

$$T1+\frac{T2}{1+r}=G1+\frac{G2}{1+r}$$

solution:

$$C1= \frac{1}{1+ \beta}(Y1+ \frac{Y2}{1+r} -G1 -\frac{G2}{1+r})$$

$$C2=\frac{(1+r)\beta}{1+ \beta}(Y1+ \frac{Y2}{1+r} -G1 -\frac{G2}{1+r})$$

What is the current account deficit (surplus) in the first period? If I(investment)=0:

CA=S=S_p + S_g

by definition (class 4):

S_g=T1-G1

S_p=Y1-T1-C1

so:

CA=S=Y1-C1 -G1

but now this is not only an accounting identity, because we have a theory about C1!

$$CA=S=Y1- \frac{1}{1+ \beta}(Y1+ \frac{Y2}{1+r} -G1 -\frac{G2}{1+r})-G1$$

reminder: what does have the CA to do with savings? let us say that $\beta (1+r) =1$, and let us call:
``permanent income"

$$\bar{Y}=\frac{1+r}{2+r}(Y1+ \frac{Y2}{1+r})$$

, and ``permanent government spending''

$$\bar{G}=\frac{1+r}{2+r}(G1+\frac{G2}{1+r})$$

then we have that consumption is equal to
$C1=\bar{Y}-\bar{G}$
and the Current Account is equal to (Jeffrey Sachs):

$$CA=S=Y1- \bar{Y} - (G1- \bar{G})$$

When is a country running a current account deficit?

• when current income is below permanent income
• when current government spending is above permanent government spending
• how does one assess permanent income or government spending? Expectations!

GROWTH AND THE CURRENT ACCOUNT

• countries that are growing should run CA deficits
• countries that foresee a decline in their income in the future should run CA surpluses ("saving for rainy day")

FISCAL POLICY AND THE CURRENT ACCOUNT

• countries whose government spending is higher than "average" should be running CA deficits (twin deficits)

Gains from Intertemporal Trade

• if the autarky (no trade) interest rate is below the World interest rate, the country will run a CA surplus.
• principle of comparative advantage: a country tends to import the goods whose autarky (pre trade) prices are high compared to world prices and viceversa.
• if the autarky interest rate is above the World interest rate, the price of today's consumption is high in autarky compared to world price: the country will import today's consumption (run a CA deficit).
• the more the autarky interest rate is different from the World interest rate, the larger the gains from intertemporal trade