Chapter 5 - Current Account Determination in a Production Economy

What is the role of investment in a production economy?

Investment consists of spending on capital goods and is an important component of aggregate demand, accounting for around 20% of GDP.

What is the significance of investment in relation to the current account?

Investment is the most volatile component of aggregate demand, making it crucial for understanding movements in the current account over the business cycle.

What are the key components derived in the theoretical model of current account determination?

The saving schedule S(r1; A1, A2), the investment schedule I(r1; A2), and the current account schedule CA(r1; A1, A2).

What types of shocks are studied in the context of current account adjustment?

Temporary productivity shocks, anticipated future productivity shocks, world interest rate shocks, and changes in the terms of trade.

What does the production function for output in period t, Qt, depend on?

Qt = AtF(It−1), where At is the level of technology and It−1 is the investment in physical capital from the previous period.

What are the three properties of the function F(·) in a production economy?

1. Output is zero when capital is zero (F(0) = 0). 2. Output increases with capital (F ′(It) > 0). 3. Output increases at a decreasing rate (F ′′(It) < 0).

What is the definition of the marginal product of capital (MPK)?

MPK = AtF ′(It−1), which is positive and declines as capital increases, indicating diminishing marginal product of capital.

How does the production function relate to the marginal product of capital?

The slope of the production function at a given level of investment equals the level of the marginal product of capital at the same level of investment.

What is the relationship between firms' investment decisions and debt in period 1?

Firms borrow to finance investment goods, with Df1 = I1, where Df1 is the debt assumed by the firm.

What is the profit function for firms in period 2?

Π2 = A2F(I1) − (1 + r1)Df1, where profits depend on output produced and the repayment of debt with interest.

How do interest rates affect firm profits?

Profits are a decreasing function of the interest rate and an increasing function of the level of productivity.

What does the investment schedule represent?

The investment schedule shows aggregate investment as a function of the interest rate and technology level, I1 = I(r1; A2).

How does an increase in productivity affect the investment schedule?

An increase in productivity shifts the investment schedule upward, indicating higher levels of investment at each interest rate.

What is the consumption-saving decision of households in a production economy?

Households receive profit payments from firms instead of an endowment, affecting their budget constraints.

What is the effect of higher interest rates on profits in period 1?

Higher interest rates lower profits, while a higher productivity factor raises profits.

What is the significance of the two-period economy model?

It allows for the analysis of investment decisions and their impact on current account dynamics over time.

What happens to output when investment is zero?

Output is nil when investment is zero, as indicated by property 1 of the production function.

What is the implication of diminishing marginal product of capital?

As more capital is added, the additional output generated from each new unit of capital decreases.

How do firms determine their optimal level of investment?

Firms assess the marginal product of capital against the cost of borrowing to decide on the level of investment.

What is the relationship between technology and investment decisions?

Higher levels of technology increase the potential output from investment, influencing firms' investment decisions.

What is the effect of anticipated future productivity shocks on investment?

Anticipated future productivity shocks can lead firms to increase current investment in preparation for higher future returns.

What role do firms play in the current account determination model?

Firms are the second economic agent incorporated into the model, influencing savings and investment schedules.

What is the impact of world interest rate shocks on the current account?

World interest rate shocks can affect the cost of borrowing and thus influence investment and savings behavior.

How does the current account relate to aggregate investment?

The current account reflects the balance of savings and investment in an economy, influenced by firms' investment decisions.

What is the significance of the profit function in period 1?

It shows how profits are determined by the level of investment and the interest rate in the initial period.

What is the equation for the period-1 budget constraint?

C1 + Bh = Π1(r0, A1) + r0Bh

What does the period-2 budget constraint express?

C2 = Π2(r1, A2) + (1 + r1)Bh

What is the intertemporal budget constraint formula?

C1 + C2/(1 + r1) = (1 + r0)Bh + Π1(r0, A1) + Π2(r1, A2)

What utility function do households maximize in this model?

U(C1) + βU(C2)

What is the Euler equation in the context of intertemporal consumption?

U′(C1) / βU′(C2) = 1 + r1

What is the relationship between period-1 consumption and the interest rate?

Period-1 consumption (C1) decreases as the interest rate (r1) increases.

How does current and expected future productivity affect period-1 consumption?

Period-1 consumption (C1) increases with current and expected future productivity.

What is the formula for national saving in period 1?

S1 = Y1 - C1

What components make up national income Y1?

Y1 = r0B0 + A1F(I0)

How is the country's net foreign asset position (B0) defined?

B0 = Bh0 - Df0

What effect does an increase in A1 have on national saving?

National saving increases unambiguously with an increase in A1.

What shifts the saving schedule to the right?

A temporary productivity increase shifts the saving schedule to the right.

What is the current account defined as?

CA1 = S1 - I1

How does the current account schedule relate to the interest rate?

The current account is an increasing function of the interest rate.

What is the equilibrium condition for the domestic interest rate in a production economy?

In equilibrium, r1 = r* (the world interest rate).

What happens to the current account when the world interest rate increases?

The current account improves from CA1 to CA'1.

What occurs when productivity in period 1 increases?

The saving schedule shifts down and to the right, improving the current account.

What happens to the current account when there is an expected future increase in productivity?

The current account schedule shifts to the left, leading to a deterioration of the current account.

What is the relationship between terms of trade shocks and endowment shocks?

Terms of trade shocks are similar to endowment shocks in their effects.

What is the profit maximization condition for firms in period 2?

TT2A2F ′(I1) = 1 + r1

What do TTt and P X t /P M t represent?

TTt represents the terms of trade in period t, defined as the relative price of the export good (oil) in terms of the import good (food).

What happens to investment when there is a change in terms of trade?

A change in the terms of trade in period 2 has the same effect on investment as a change in productivity in period 2.

What is the household's intertemporal budget constraint in a two-good economy?

C1 = C(r1−, TT1A1+, TT2A2+)

How is national income represented in this economic model?

National income is represented as Y1 = r0B0 + TT1A1F(I0).

What does the current account schedule depend on?

The current account schedule depends on CA(r1+, TT1A1+, TT2A2−).

What is the effect of a temporary terms of trade improvement?

It produces an increase in saving, an improvement in the current account, and no change in investment.

What is the anticipated effect of a future improvement in terms of trade?

It causes a fall in saving, an expansion in investment, and a deterioration of the current account.

What defines a giant oil discovery?

A giant oil discovery is defined as a discovery of an oil or gas field containing at least 500 million barrels of ultimately recoverable oil equivalent.

What is the median value of a giant oil discovery in terms of GDP?

The median value of a giant oil discovery is 9 percent of a year's GDP.

How long does the average delay from discovery to production of oil typically take?

The average delay is estimated to be between 4 and 6 years.

What happens to investment upon news of a giant oil discovery?

Investment experiences a boom that lasts for about 5 years.

What is the effect on saving after a giant oil discovery?

Saving declines and stays below normal for about 5 years before rising sharply.

What occurs to the current account after a giant oil discovery?

The current account deteriorates for 5 years and then experiences a reversal with a peak in year 8.

What is the relationship between investment and the marginal product of capital?

Firms invest up to a point where the marginal product of capital equals the gross interest rate.

How does an expected increase in productivity of capital affect the investment schedule?

It shifts the investment schedule up and to the right.

What effect does an increase in current productivity of capital have on the saving schedule?

It shifts the saving schedule down and to the right.

What is the effect of an increase in the world interest rate on the current account?

It causes an improvement in the current account, an increase in saving, and a decrease in investment.

What is the significance of the intertemporal model of current account determination?

It is the backbone of many models in international macroeconomics.

What is the relationship between terms of trade shocks and productivity shocks?

Terms of trade shocks have effects similar to productivity shocks.

What happens to the current account schedule with an expected increase in A2?

It shifts the current account schedule up and to the left.

What does the investment schedule look like in the (I1, r1) space?

The investment schedule is downward sloping.

How does an increase in A1 affect the current account?

It produces an improvement in the current account.

What is the effect of an expected increase in A2 on the current account?

It causes a deterioration in the current account.