Practice Problems on Current Account

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1 Practice Problems on Current Account 1- List de categories of credit items and debit items that appear in a country s current account. What is the current account balance? What is the relationship between the current account balance and next exports? Credit items in the current account are exports of goods and services and income receipts from abroad. Debit items in the current account are imports of goods and services, income payments to foreigners, and net unilateral transfers. Adding all of the credit items and subtracting all of the debit items gives the current account balance. The current account balance equals net exports plus net factor payment plus net unilateral transfers. 2- What is the key difference that determines whether an international transaction appears in the current account or the capital and financial account? The current account includes only the trade of currently produce goods and services. Trades of existing assets are counted in the capital and financial account. 3- An American publisher sells $200 worth of books to a resident of Brazil. By itself, this item is a credit item in the U.S. current account. Describe some offsetting transactions that could ensure that the U.S. current account and the capital and financial account balances would continue to sum to zero. The sale of books from United States to Brazil is a credit item in U.S. current account. Offsetting transactions include anything that is a debit item in either the current account or the capital and financial account. Some examples of offsetting transactions are: (1) A U.S. citizen buys $200 worth of stock in a Brazilian company, so that the offsetting debit item is an increase in U.S. owned assets abroad, which is a debit in the capital and financial account. (2) A U.S firms imports $200 worth of nuts from Brazil, so the offsetting debit item is an import of goods, which is a debit in the current account. 4- How do a country s current account, capital account and financial account balances affect its net foreign assets? If country A has greater net foreign assets per citizen than does country B, is country A necessarily better off than country B? In any period, the net amount of new foreign assets that a country acquires equals its current account surplus, which in turn must equal its capital and financial account deficit. A country with greater net foreign assets than another is not necessarily better off. What

2 really counts is total national wealth, which consists of both net foreign assets and net domestic assets. For example, the United States has lower net foreign assets than other countries, but has one of the world s highest levels of total national wealth per citizen. 5- Explain why, in a small open economy, (a) national saving does not have to equal investment, and (b) output does not have to equal absorption. In a small open economy, saving does not have to be equal to investment. Saving can be used to finance domestic investment or it can be lent abroad. So saving equals investment plus net exports. Similarly, output need not equal absorption. Absorption is a country s total spending on consumption, investment, and government purchases. Absorption may be different from output because some output may be exported. The difference between output and absorption is net exports. 6- Generally, what types of factors will cause a small open economy to run a large current account deficit and thus borrow abroad? More specifically, what two major factors contributed to heavy LDC borrowing in the 1970s? A small open economy is likely to run a large current account deficit and to borrow abroad for two main reasons. First, there may be an increase in the expected future marginal product of capital. This shifts the investment curve, reducing the current account balance. The second reason for foreign borrowing is temporary supply shocks that cause absorption to exceed output for a time. In the 1970s both factors contributed to heavy borrowing by LDCs. Many were borrowing to try to increase growth by increasing their capital stock, because they believed the future marginal product of capital was high. Because the LDCs were poor and had little domestic saving, they had to borrow from abroad to increase investment. And the oil price shocks of and caused a further reduction in national saving, so the LDCs had to borrow even more from abroad. 7- In a world whit two large open economies, what determines the world real interest rate? What relationship between the current accounts of the two countries is satisfied when the world real interest rate is at its equilibrium value? In a world with two large open economies, the world real interest rate is determined such that desired international lending by one country equals desired international borrowing by the other country. When the world real interest rate is at its equilibrium value, the current accounts of the two countries sum to zero.

3 8-How does an increase in desired national saving in a large open economy affect the world real interest rate? An increase in desired national saving in a large open economy reduces the world real interest rate. The shift to the right in the saving curve increases the country s current account at the current world real interest rate, so the international asset market is out of equilibrium. To restore equilibrium, the world real interest rate must fall. 9- A large country imposes capital controls that prohibit foreign borrowing and lending by domestic residents. Analyze the effects on the country s current account balance, national saving, and investment, and on domestic and world real interest rate. Assume that, before the capital controls were imposed, the large country was running a capital and financial account surplus. In Fig. 5.3, before the capital controls are imposed, the home country has a current account deficit of the amount CA, while the foreign country has a matching current account surplus. The effect of the capital controls is to make saving equal investment in each country. In the home country, the real interest rate rises, investment declines, saving increases, and current account balance increases to zero. The world real interest rate (the interest rate in the foreign country) declines. r S -CA r S for CA for r w I I for Figure 5.3 S I S d, I d S d for I d for 10- The chief economic advisor of a small open economy makes the following announcement: We have good news and bad news: The good news is that we have just had a temporary beneficial productivity shock that will increase output; the bad news is that the increase in output and income will lead domestic consumers to buy more imported goods, and our current account balance will fall. Analyze this statement, taking as given that a beneficial productivity shock has indeed occurred.

4 The shock shifts the saving curve to the right, with no change in the investment curve, since the future marginal product of capital is unaffected. Since income rises and saving rises, consumption rises, but less than income. Thus, although imports rise somewhat, the amount is small, so that the current account increases, it doesn t fall. The statement is false. 11- The governments of developed economies in the early 1980's increased its expenditures (that is G). This increased the government's budget deficit. Assume that the real interest in these developed economies is equal to the world real interest rate. Answer the question based only on the information provided in this question. a. How the rise in the budget deficit will impact national savings of these economies? The national savings will go down. National savings is equal to S pvt + S gov. A fall in S gov due to the rise in the budget deficit lowers national savings. b. How will the rise in the budget deficit impact the current account of these economies? The current account will go down. National savings have fallen with no change in the investment demand schedule and as CA = S - I a fall in S with no change in I implies a fall in CA. c. How will the rise in the budget deficit impact the magnitude of the net international debt position of these economies? As the current account goes down the magnitude of the international debt has to rise. Change in debt is equal to the current account. 12- East Asia Growth, Growth and Income Inequality i) As discussed in class the level of income inequality has decreased in the HPAE countries, on the other hand many countries in Latin America have seen a rise in their level of income inequality. Provide an explanation regarding why income inequality may have decreased in HPAE economies and increased in the Latin American economies. [Additional Information: For the last 25 years the average growth rate of percentage of people with basic education is much higher in HPAE economies relative to Latin American economies As discussed the real wage is equal to the marginal product of labor (w=mpn). In the HPAE economies the rise in education, in particular of the less educated people, lowers the dispersion on education across people this makes the MPN across

5 individuals be more similar. This implies that the dispersion in real wages drop and hence income inequality drops. On the other hand in Latin American economies the rise in income inequality is due to two reasons (i) the education growth rate of lower educated people is not high (ii) economic liberalization has lead to skill-based technical change. Both these features lead to a bigger variance (dispersion) in real wages. ii) Average rates of Investment in new plant and capital is also much higher (40% of GDP) in the HPAE economies relative to Latin American economies (20% of GDP). How will the difference in the growth rate of educational attainment (as discussed in part (i)) explain the differences in the average rate of Investment in these economies. As the HPAE economies have had higher TFP growth due to greater education growth, higher TFP growth leads to a rise in expected MPK that raises the incentive to invest. As the TFP growth is higher for HPAE economies it also follows that Investment will be higher in HPAE economies. 13- Suppose the U.S government raised its expenditures and did not change tax rates. How will this policy affect the budget deficit? In particular, how will this change in government policy affect real wages, employment and real interest rates? The increase Government expenditures does not affect the underlying technology and hence does not affect the MPN curve. Hence labor demand is unaffected. This ensures that the real wages and the real GDP are unchanged. The increase in the Budget deficit unambiguously lowers the aggregate savings in the economy. The investment schedule is also unaffected by the change in the government expenditures. However, the drop in aggregate savings causes the real interest rate to increase if the economy is closed or if it is big compared to the world economy. If so, the equilibrium level of investment will drop. 14- On the next page you will see graphs of real GDP growth, the current account, and the net foreign assets of the U.S. The net foreign asset position (labeled U.S. net investment position) is the holdings of foreign assets by U.S. residents minus the holdings of U.S. assets by foreign residents. Note that real GDP growth is falling from early 1990 to early 1991, and begins to rise after 1991.

6

7 a. From 1982, the net foreign asset position falls from a positive position to a substantial negative position. Explain this movement in light of the observed behavior of the current account during this time period. Since 1982, the U.S. has had a persistent current account deficit. This means that on the net it is borrowing from the rest of the world. Additional borrowings mean that the rest of the world is accumulating more claims on the U.S. than the U.S. is accumulating claims on the rest of the world, hence the net investment position went from a positive number to a negative number. b. Also recall that during the early 80's the budget deficit was increasing in the U.S.. Further the real interest rates in the U.S. during the early 80's where also very high. Using diagrams explain the relation between the budget deficit, the large current account deficit, and the high real interest rates during the early 80's. A rise in the budget deficit has the effect of lowering aggregate U.S. savings. Further, as the U.S. is a large open economy this has the effect of raising the real interest rates and increasing the Current account deficit (see Graphs). c. Further, explain why the current account deficit shrunk during period. The was a period of a recession. This can be viewed as a temporary adverse productivity shock, which lowers the expected marginal productivity of capital in the U.S., hence the incentive to invest and borrow is lowered, which shrinks the current account deficit. 15- Consider a world economy where capital is free to move from one location to another via international Financial Markets. a. In such a world economy, what determines the world real interest rate? What should be the relation between the marginal productivity of capital and the world real interest rate? How is this relation changed if different locations in the Global Economy have different risks of investment? Ignoring risk, international capital will be allocated to ensure that all arbitrage opportunities are exploited, hence expected MPK(i) = r for country i, where r is the expected real interest rate. Finally, if different locations have different magnitudes of risk, then this the international allocation of capital is determined to satisfy the condition that expected MPK(i) = r +rp(i), where rp(i) is the riskpremium in a given location. 16- (Application to Brazil) There has recently (1998) been considerable economic turmoil in Brazil. The stock index in this country sharply dropped and there was considerable outflow of capital from Brazil.

8 Using ideas developed in class, provide an explanation regarding why the financial market in Brazil dropped sharply and why there was an outflow of capital from Brazil. A rise in the risk of investing in Brazil increases Brazil's rp, hence investors need higher returns to invest in Brazil. To achieve higher expected returns on capital (i.e., higher expected MPK), the stock of capital has to shrink that is, there will be outflow of capital or fewer projects undertaken in Brazil. This follows from the key property of diminishing marginal product of capital. A rise in risk hence lowers the amount of investment in new physical capital and raises the discount rate for all projects in Brazil this, in itself is enough to lower the stock market value in Brazil. 17- German Reunification and the current account On the next page is a graph of Germany's current account surrounding the period of reunification in Provide an explanation of why Germany's current account went from a surplus before reunification to a deficit after reunification. The current account provided on the next page is for the combined Germany. Unification rose the MPK, that is, the demand for Investment goods. This leads to a fall in the current account surplus or a widening of the current account deficit. 18- From the U.S. had an increasing government budget deficits (due to higher government spending and lower tax rates) and current account deficits, and the value of the dollar was increasing. Provide an explanation, of this behavior of exchange rates, government budget deficits, and current account deficits. The combination of lower taxes and increased government expenditures raise current demand for investment goods and lower current aggregate savings. This unambiguously raises current real interest rates. As real interest rates increase in the U.S this causes the dollar to appreciate. The current account deficit widens as the demand for investment

9 increased (because of lower corporate tax rates) and because the aggregate savings in the economy dropped. This policy will also cause the growth rate of the economy to be higher. 19- Globalization and developing economies. Consider a small Eastern European economy, for example Hungary. Prior to 1990 Hungary was essentially a closed economy. In this closed economy the domestic real interest rate was 0.5% per annum. Beginning from 1990 Hungary opened its economy to international trade and allowed free mobility of international capital. The world real interest rate is 3% per annum. Assume that the opening of the Hungarian capital market has no effects on the investment schedule and the savings schedule. The effect of opening the Hungarian economy in this problem is simply that the real interest rate in Hungary is now higher (and equal to the world real interest rate) than it was in a closed economy. a. How will the opening of the Hungarian economy affect the magnitude of physical investment in Hungary? Magnitude of physical investment has to go down as the cost of borrowing increases. b. How will the opening of the Hungarian economy affect the magnitude of Hungarian national savings? Magnitude of national savings will go up as households can earn a higher rate of return on their savings. c. How will the opening of the Hungarian economy affect the future Hungarian real GDP? The level of future real GDP will have to go down as the level of investment in new plants and capital today dropped. d. How will the opening of the Hungarian economy affect its current account? The current account in Hungary will go up as savings rose and investments in physical capital fell. Recall: CA = S - I.

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