Transcript Ch6a - YSU

International Finance
Chapter 6
Balance of Payments I: The Gains from
Financial Globalization
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Chapter Introduction
Continuing our discussions on the balance of
payments and net foreign wealth, in this chapter, we
will try to gain some insight on:
• Constraints on international borrowing and
lending
• Gains on consumption and investment for an
open economy with a long-run view
• International diversification
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Chapter Outline
• Long-Run Budget Constraint
• Gains on consumption smoothing
• Gains on efficient investment
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Long-Run Budget Constraint
• How much a country can borrow?
• Instead of a static approach, we adopt a dynamic
approach to study an economy as it evolves over
time, aka an intertemporal approach.
• The LRBC tells us how and why a country must
live within its means in the long run.
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Long-Run Budget Constraint
• You borrow $100,000 with10% annual interest
rate.
• What happens to your debt if you pay neither principal
nor interest?
• Pyramid or Ponzi scheme. Sustainable?
• In the long run, lenders will not allow debt to grow
larger, which is the essence of the long-run
budget constraint.
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Long-Run Budget Constraint
Here are some of the assumptions we make:
• Prices are perfectly flexible. Analysis is done in real terms.
• The country is a small open economy. The country
cannot influence prices in world markets for goods and
services.
• All debt carries a real interest rate r*, the world real
interest rate, which is constant. The country can lend or
borrow an unlimited amount at this interest rate.
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Long-Run Budget Constraint
Here are some of the assumptions we make:
• The country pays r* on its liabilities L and get paid r* on its
assets A. Hence, the net interest income equals to r* (A-L),
or r*W, where W is the external net wealth.
• There are no unilateral transfers, no capital transfer, and
no capital gains on W. So, there are only two nonzero
items in the current account: the trade balance and net
factor income from abroad, r*W.
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Long-Run Budget Constraint
The change in external net wealth from end of year N − 1 to
end of year N:
WN 
WN  WN –1

 TBN 

r *WN –1

Change in external wealth
this period
Trade balance
this period
Interest paid/received
on last period's external wealth
Solving for wealth at the end of year N:
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Long-Run Budget Constraint
The Budget Constraint in a Two-Period Example
At the end of year 0,
We assume that all debts owed or owing must be paid off,
and the country must end that year with zero external
wealth.
*
W1  0  (1  r )W0  TB1
At the end of year 1:
Then: W1  0  (1  r * ) 2 W1  (1  r * )TB0  TB1
The two-period budget constraint equals:
(1  r* ) 2 W 1  (1  r* )TB0  TB1
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Long-Run Budget Constraint
The Budget Constraint in a Two-Period Example
Present Value Form
By dividing the previous equation by (1 + r* ), we find a
more intuitive expression for the two-period budget
constraint:
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Long-Run Budget Constraint
The Budget Constraint in an infinite period
If N runs to infinity, we get an infinite sum and arrive at the
equation of the LRBC:
 (1  r )W1

*
Minus the present value of
wealth from last period
TB3
TB1
TB2
TB4
 TB0 




*
* 2
* 3
* 4
(1  r )
(1  r )
(1  r )
(1  r )

Present value of all present and future trade balances
A debtor (surplus) country must have future trade balances
that are offsetting and positive (negative) in present value
terms.
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Long-Run Budget Constraint
A Long-Run Example: The Perpetual Loan
The formula below helps us compute PV(X) for any stream
of constant payments:
For example, the present value of a stream of payments
on a perpetual loan, with X = 100 and r* = 0.05, equals:
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Long-Run Budget Constraint
Implications of the LRBC for Gross National
Expenditure and Gross Domestic Product
Since TB  GDP  GNE.
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Long-Run Budget Constraint
The long-run budget constraint says that in the long run, in
present value terms, a country’s expenditures (GNE) must
equal its production (GDP) plus any initial wealth.
The LRBC therefore shows how an economy must live
within its means in the long run.
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Long-Run Budget Constraint
• In reality, are lending rates equal to borrowing rates in
international debt markets?
• Do all countries have the same creditworthiness?
• How would exchange rates affect the value of a
country’s net foreign wealth?
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Sovereign Ratings and Public Debt Levels: Advanced Countries Versus Emerging
Markets and Developing Countries, 1995 to 2005
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Gains on Consumption Smoothing
• We assume that an economy prefers a smooth path of
intertemporal consumption.
• Is it easier for an open economy to achieve
consumption smoothing than a closed one?
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Gains on Consumption Smoothing
The Basic Model
• Production of GDP (Q) employs labor as the only input
and is subject to shocks.
• GNE = C, assuming I and G are zero.
• W−1 = 0.
• The subject country is small and it finances at the world
real interest rate r* (= 5% per year in our example).
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Gains on Consumption Smoothing
The Basic Model is a special case of the LRBC:
 Present va lue of TB  Present va lue of Q  Present
of
C

va
lue











Initialwealth is zero
0
Present value of GDP
Present value of GNE
or,
Present va lue of Q  Present
of
C
va
lue




 
Present value of GDP
Present value of GNE
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Gains on Consumption Smoothing
Closed vs. Open Economy: No shocks to GDP
Output equals consumption. Trade balance is zero. Consumption is smooth.
No gains from financial globalization!
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Gains on Consumption Smoothing
Closed Economy: Temporary Shocks to GDP
Output equals consumption. Trade balance is zero. Consumption is not smooth.
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Gains on Consumption Smoothing
Open Economy: Temporary Shocks to GDP
A trade deficit is run when output is temporarily low. Consumption is smooth. The lesson
is clear: When output fluctuates, a closed economy cannot smooth consumption, but an
open one can.
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Gains on Consumption Smoothing
In general:
• Initially, Q = C and W = 0. The LRBC is satisfied.
• Now, GDP falls by ΔQ at t = 0 and then returns to its
prior value for t ≥ 1.
• Consumption changes by ΔC for periods. ΔC < ΔQ
since consumption is assumed to be smoothed.
• In an open economy, a trade deficit (ΔQ – ΔC) would
occur at t = 0. So would external net wealth.
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Gains on Consumption Smoothing
• A loan of ΔQ − ΔC in year 0 requires interest payments
of r*(ΔQ − ΔC) in later years.
• If the subsequent trade surpluses of ΔC are to cover
these interest payments, then we know that ΔC must be
chosen so that:
r *  ( Q  C ) 

Amount borrowed
in year 0


C

Trade surplus
in subsequent years
Interest due in subsequent years
• Rearranging to find ΔC:
r*
C 
Q
*
1 r
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Gains on Consumption Smoothing
Smoothing consumption when a shock is permanent
With a permanent shock, output will be lower by ΔQ in all
years, so the only way either a closed or open economy
can satisfy the LRBC while keeping consumption smooth
is to cut consumption by ΔC = ΔQ in all years.
• consumers can smooth out temporary shocks—they
have to adjust a bit,
• but the adjustment is far smaller than the shock itself—
yet they must adjust immediately and fully to permanent
shocks.
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Gains on Efficient Investment
• For an open economy, global allocation of capital stock
provides opportunities for investments, technological
advancement, and economic growth.
• Built upon the Basic model, the new production function
has two inputs – labor and capital.
• The LRBC, therefore, includes I as a component of
GNE. Government spending is still assumed to be zero.
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Gains on Efficient Investment
0
 Present va lue of TB
Initialwealth is zero
Present va lue of Q  Present
va lue of C  Present va lue ofI


 
Present value of GDP
Present value of GNE
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Gains on Efficient Investment
Initially, Q = 100, C = 100, I = 0, TB = 0, and W = 0.
An Open Economy with Investment and a Permanent Shock The economy runs a trade
deficit to finance investment and consumption in period 0 and runs a trade surplus when
output is higher in later periods. Consumption is smooth.
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
Gains on Efficient Investment
Generalizing
• Suppose that a country starts with zero external wealth,
constant output Q, consumption C equal to output, and
investment I equal to zero.
• An investment opportunity appears requiring ΔK units of
investment spending in year 0. This investment will generate
an additional ΔQ units of output in year 1 and all later years.
• The present value of these additions to output is,
Change in present value of output

Q
Q
Q



*
* 2
* 3
(1  r )
(1  r )
(1  r )

Q
r*
• Investment will increase the present value of consumption if
and only if ΔQ/r* ≥ ΔK.
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Gains on Efficient Investment
• Investment will increase the present value of consumption if and
only if ΔQ/r* ≥ ΔK. Rearranging,
• Dividing by ΔK, investment is undertaken when
• Firms will take on investment projects as long as the marginal
product of capital, or MPK, is at least as great as the real interest
rate.
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Gains on Efficient Investment
The Oil Boom in Norway
Following a large increase in oil prices in the early 1970s, Norway invested heavily to
exploit oil fields in the North Sea. Norway took advantage of openness to finance a
temporary increase in investment by running a very large current account deficit.
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Gains on Efficient Investment
Can Poor Countries Gain from Financial Globalization?
If the world real interest rate is r* and a country has
investment projects for which MPK exceeds r*, then the
country should borrow to finance those projects.
Production Function Approach
where θ is a number between 0 and 1 that measures the
contribution of capital to production, or the elasticity of
capital with respect to output. θ is estimated to be 1/3.
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Gains on Efficient Investment
Hence, the marginal product of capital is
Assuming countries have the same level of
productivity, A = 1, our model implies that the poorer
the country, the higher its MPK, the more profitable
investing in the country.
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Gains on Efficient Investment
Why Doesn’t Capital Flow to Poor
Countries?
If poor and rich countries share
the same level of productivity (a
common production function),
then MPK must be very high in
poor countries, as shown in panel
(a).
For example, if B represents
Mexico and R the United States,
we would expect to see large
flows of capital to poor countries,
until their capital per worker k
and, hence, output per worker q
rise to levels seen in the rich
world (movement from point B to
point R).
The result is convergence.
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Gains on Efficient Investment
So, why doesn’t capital flow from rick to poor countries?
• In our model, we assume countries have the same
level of productivity. In reality, poor countries have
much lower level of productivity than rich ones.
• Notice that MPK is an increasing function of A. With a
smaller A, poor countries become less attractive to
foreign capital.
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Gains on Efficient Investment
Why Doesn’t Capital Flow to Poor
Countries? (continued)
This doesn’t happen in reality. Poor
and rich countries have different
levels of productivity (different
production functions) and so MPK
may not be much higher in poor
countries than it is in rich countries,
as shown in panel (b).
The poor country (Mexico) is now at C
and not at B. Now investment occurs
only until MPK falls to the rest of the
world level at point D.
The result is divergence. Capital per
worker k and output per worker q do
not converge to the levels seen in the
rich country.
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Gains on Efficient Investment
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Gains on Efficient Investment
Some thoughts on productivity A
• Technical efficiency (technology, management skills,
etc.)
• Social efficiency (cultures, public policies, religions,
etc.)
• Country specific risk (risk premium)
Also, is foreign aid effective?
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