Lecture 1 Basic 2 Period Inter-temporal Model

8/12/2019 Lecture 1 Basic 2 Period Inter-temporal Model

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Advanced International

Finance (Econ 751)Preliminaries



A quote from Keynes

―The study of economics does not seem to require any specialized giftsof an unusually high order. Is it not, intellectually regarded, a very easysubject compared with the higher branches of philosophy and purescience? Yet good, or even competent, economists are the rarest ofbirds. An easy subject, at which very few excel!

The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must reach ahigh standard in several different directions and must combine talentsnot often found together.

He must be mathematician, historian, statesman, philosopher — insome degree. He must understand symbols and speak in words. Hemust contemplate the particular in terms of the general, and touchabstract and concrete in the same flight of thought. He must study thepresent in the light of the past for the purposes of the future. No part ofa man’s nature or his institutions must lie entirely outside his regard.‖



Whither modern macroeconomics?

• Buiter:―…the typical graduate macroeconomics and monetaryeconomics training received at Anglo-American universitiesduring the past 30 years or so, may have set back by decadesserious investigations of aggregate economic behavior andeconomic policy-relevant understanding….a privately and

socially costly waste of time and other resources.

• Most mainstream macroeconomic theoretical innovationssince the 1970s have turned out to be self-referential, inward-looking distractions at best. Research tended to be motivatedby internal logic, intellectual sunk capital …rather than by a

powerful desire to understand how the economy works - letalone how the economy works during times of stress andfinancial instability.‖

• Goodhart: ―[Modern macroeconomics]…excludes everything I

am interested in”.



The Essay (30%)

• Critical review of a journal article (choice of 3) – Due on Friday 7 October, 5.00pm

• START EARLY– the papers are challenging and will push beyond

material covered in lectures. – Discuss the technical aspects of models with each

other. But form your own views.

• Plagiarism…



Exam and other points

• Open-ended ―Oxford-style‖ essay questions

– No rewards for memory of formulae!!

– E.g. “Are US labor markets too flexible?”

• “Sloppy drafting reflects sloppy thinking”

– Mervyn King, Governor, Bank of England

• ―Lots of models‖ – but actually you will just seea few model classes.



Course overview – 1

• How should we begin to think about somebig questions in international finance, eg:

– The huge US current account deficit andChinese current account surplus

– The sovereign debt crisis in Greece

– Should countries peg their currency (to thedollar) or let them float?

– The role of the IMF in crisis prevention



Course overview – 2

• Tour of the world through models – The aim is to provide an analytical framework

and sharpen our intuition about policy

problems.

• Three broad classes of model: – Intertemporal optimising models

– Game-theoretic models

– Principal Agent models



Topics - 1

1. The current account

• Why do countries run current account surpluses

or deficits? When are they sustainable?• Do these models help us understand the debate

on ―global imbalances‖? Can we put flesh onBernanke’s notion of the ―saving glut‖?

• Some links to the modern theory of consumption



Topics – 2

2. Sovereign debt and default• Why do countries default? How can creditors

ensure repayment?

• Why does capital seem to flow in the ―wrong‖direction, i.e from the poor to the rich nations?

• Notion of default as a key financial friction in

models; the role played by moral hazard; theidea of a country’s reputation in financialmarkets

•

Does the IMF help or hinder the debtor-creditorrelationship?



Topics – 3

3. Understanding financial crises• The family resemblance in exchange rate, banking

and debt crises

• Are crises driven by deteriorating economicconditions or do they come from the ―blue‖ asinvestors’ beliefs sour suddenly?

• Strategic foundations of financial crises

• How can we prevent and manage financial crises?



Topics – 4, 5

4. Financial frictions in the macroeconomy

– How should we think of banks? What role dothey play in the macroeconomy?

– Why do some firms borrow from banks andothers from the international capital markets?

– How might ―credit crunches‖ arise?

5. Wrap-up: shedding light on the GFC



Topic 1

The inter-temporal approachto the current account

Note: why countries borrow depends on the income, Y of the country and in

and in return it determines autarky interest rate, rA .



The two period model

• Small open economy populated by arepresentative agent. There is a single good(“corn”).

• Since population is “size 1”, the variables canbe regarded as national aggregates (i.e.macroeconomic)

•

Output of corn at each date (t=1, 2) is given tous by endowment, and cannot be stored forlater consumption.



Model set-up

• As in microeconomics, we maximize the utility

of the agent – over his lifetime – subject to a

budget constraint.

• Utility in each period depends on the agent’s

consumption level. And we need to take into

account how impatient to consume he is.

• Let r be the real interest rate that prevails on

world capital markets (exogenously given).



Optimization problem

• Maximise

• Subject to



First order (Euler) condition

• As in microeconomics, the marginal rate of

substitution (between present and future

consumption) must be equated with the

relative price (of future consumption in termsof present consumption)



A special case

•Suppose that the representative agent and financialmarkets discount the future at the same rate, i.e. b=1/1+r,then we end up with a flat consumption path

• The Euler equation tells us about the motion of aggregateconsumption in the economy. When b 1/1+r, the

consumption path will “tilt”.

• The model suggests that a country seeks to smoothconsumption over time.



A graphical representation



Definition

• The current account balance is the change invalue of its net claims on the rest of the world – the change in its net foreign assets.

• If Bt+1 denotes the value of foreign assets atthe end of some period then

CAt=Bt+1-Bt=Yt-Ct+rBt

• In our simple model, CA1=Y1-C1 (note B1=0)



Gains from inter-temporal trade

• Imagine a world of autarky, where we are prevented fromborrowing/lending. In this case, the real interest rate is“rA”. The Euler equation consistent with this state ofautarky (where we consume what we produce) will be

• If rA>r, then the autarky price is below the world relative

price of future consumption. So we would like to export“future consumption” and import “present consumption”.

• It helps motivate why some countries might run deficitsand others run surpluses



Permanent vs. temporary shocks

• If b= 1/1+r, then permanent shocks to output will notchange the current account, whereas temporary shockscan produce surpluses/deficits.

• Suppose our corn crop rises by 10% today, but that weexpect that the crop will return to normal levelstomorrow. Output variation is temporary.

• Might make sense to lend some of our temporarilyhigh output to foreigners, i.e run a current accountsurplus at date 1.



• Suppose, instead, our island economyexperiences a drought that reduces outputforever, due to climate change.

• Now it won’t make much sense to borrowagainst future income, since we know outputis forever lower.

•

It suggests that we have to make do by cuttingconsumption in all periods by the size of thedecline in our corn crop.



• Our autarky equation becomes

• A higher Y1 (but constant Y2) means that rA<r and thecountry runs a first period surplus in line with our intuition.

•

But if Y2 rises by the same amount as Y1, there is no changein rA. So a permanent change does not impact the currentaccount.



The model with investment

• Countries do not just borrow to smooth

consumption. They borrow for investment in

projects.

• Instead of an endowment economy, output is

now produced with capital according to a

production function



• Suppose there is no depreciation of capital,

then capital accumulation is the sum of pre-

existing capital and any new investment

• So private wealth is our holding of foreign

assets and the stock of foreign capital

• And national saving is



The inter-temporal budget constraint

• If we start with no debt and, when time ends,

we make sure that our economy does not hold

uncollected claims on foreigners, we get



Optimisation problem



First order conditions

• Note that we obtain the Euler condition again,

and a second equation stating that investment

in domestic capital should continue to the

point where the marginal return on it is thesame as that on a foreign loan



Fisher “separation”

• Observe that there is a separation of consumption andinvestment decisions. The equations tell us that thedesired capital stock will be independent ofconsumption –

country is small and savings decisions don’t change theinterest rate at which investments are financed on theworld capital market

– there is a single consumption good. Allowing traded andnon-traded goods can link consumption and investment

• The microeconomics motivates the separation ofownership and control. A key result in financialeconomics



Graphical representation



Summary

• The two period model is at the core of modernmacroeconomics (and financial economics)

• Applied to an open economy setting, it shows

– How countries gain from inter-temporal trade – Explains how current account deficits and surpluses may

arise due to consumption smoothing

– Highlights the importance of distinguishing betweenpermanent and temporary shocks

– Illustrates how national saving in excess of domestic capitalformation flows into net foreign asset accumulation (thecurrent account)



CA imbalances – good or bad?

Lecture 1 Basic 2 Period Inter-temporal Model

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