Chapter 3 - Intemporal Theory of the Current Account

What defines a 'small' economy in the context of international macroeconomics?

An economy where world prices and interest rates are independent of domestic conditions.

What characterizes an 'open' economy?

An economy that trades in goods and financial assets with the rest of the world.

Name two examples of developed small open economies.

The Netherlands and Switzerland.

What are emerging small open economies? Give an example.

Economies like Argentina and Chile that are developing but still engage in international trade.

What is a closed economy? Name one example.

An economy that does not engage in international trade, such as North Korea.

What is the significance of the transversality condition in the model economy?

It states that bond holdings must be zero at the end of the final period.

What does the intertemporal budget constraint represent?

It equates the present discounted value of consumption to the present discounted value of endowment and initial wealth.

What is the slope of the intertemporal budget constraint?

The slope is - (1 + r1), indicating the trade-off between present and future consumption.

What does a downward-sloping indifference curve indicate?

It shows that more consumption in one period leads to less consumption in another period, reflecting preferences.

What is the optimal consumption path in the context of the intertemporal budget constraint?

It is the point where an indifference curve is tangent to the intertemporal budget constraint.

What does the lifetime utility function assume about household preferences?

It assumes that happiness increases with consumption in both periods.

What is the consumption Euler equation?

It is the optimality condition that states U′(C1) = β(1 + r1)U′(C2).

What does the parameter β represent in the lifetime utility function?

The subjective discount factor, indicating how much less households value future consumption.

What happens at point D on the intertemporal budget constraint?

It is feasible but violates the transversality condition because it leaves money on the table at the end of period 2.

What is the relationship between the endowment point and optimal consumption path?

The endowment point (Q1, Q2) is the starting point, while the optimal path (point B) represents higher utility consumption choices.

What does the term 'indifference curve' refer to?

It is a curve representing different consumption paths that yield the same level of utility.

How does the household maximize its lifetime utility?

By choosing consumption levels in periods 1 and 2 that satisfy the intertemporal budget constraint.

What does the downward slope of the intertemporal budget constraint imply for consumption choices?

It implies that increasing consumption in one period necessitates decreasing consumption in the other period.

What is the significance of the optimal consumption path being above the endowment point?

It indicates that the household borrows in period 1 and repays in period 2.

What does the term 'present discounted value' refer to in the context of the intertemporal budget constraint?

It refers to the value of future cash flows discounted back to the present.

What happens to consumption if the household's initial asset position is zero?

The household must borrow to consume more than its endowment in period 1.

What is the implication of indifference curves not crossing?

It indicates that each consumption path corresponds to a unique level of utility.

What does the optimality condition derived from the maximization problem indicate?

It shows the relationship between marginal utilities of consumption in both periods adjusted for interest rates.

What does the Euler equation express in terms of consumption and interest rates?

It states that at the optimal consumption path, the negative of the marginal rate of substitution equals the negative of the gross interest rate.

What is the Interest Rate Parity Condition under free capital mobility?

The domestic interest rate (r1) must equal the world interest rate (r*).

What happens when r1 is greater than r*?

Arbitrage opportunities arise, allowing borrowing abroad at r* and lending domestically at r1 for infinite profits.

What is the implication of a small open economy's saving decisions?

The saving decisions do not affect the world interest rate.

What does the intertemporal budget constraint represent in a small open economy?

It can be interpreted as the country's intertemporal resource constraint.

What are endogenous variables in the context of the intertemporal model?

Endogenous variables are determined within the model, such as consumption (C1, C2) and interest rate (r1).

What are exogenous variables in the intertemporal model?

Exogenous variables are determined outside of the model, such as r0, B0, Q1, Q2, and r*.

What does the trade balance (TB) represent?

The trade balance is the difference between output and consumption (TB1 = Q1 - C1, TB2 = Q2 - C2).

How is the current account (CA) calculated?

The current account equals the trade balance plus net investment income (NII) (CA1 = TB1 + r0B0, CA2 = TB2 + r1B1).

What is the effect of a temporary decline in output on consumption?

Households will want to cut both C1 and C2, smoothing consumption over time.

What principle emerges regarding temporary and permanent output shocks?

Economies tend to finance temporary shocks and adjust to permanent ones, leading to large movements in the current account for temporary shocks.

What occurs when households anticipate an increase in future income?

Current consumption increases, leading to a deterioration of the current account despite good news about future income.

What is the key insight regarding temporary income shocks?

Countries use the current account to smooth consumption over time, with positive shocks improving and negative shocks deteriorating the current account.

What happens to consumption in response to permanent income shocks?

Countries adjust consumption without significant movement in the current account.

What is the relationship between the trade balance and the current account?

The trade balance is a component of the current account, which also includes net investment income.

How do households respond to a temporary output shock?

They may run a larger trade deficit in the first period and finance it by acquiring additional foreign debt.

What does the slope of the intertemporal budget constraint represent?

The slope represents the negative of the gross interest rate (-(1 + r1)).

What is the significance of point B in the graphical representation of equilibrium?

Point B is where the intertemporal resource constraint and the indifference curve are tangent, satisfying the equilibrium conditions.

What does the adjustment to a permanent decline in output imply?

The decline in consumption is expected to be close to the output decline, with little impact on the trade balance.

What does the intertemporal budget constraint imply for consumption decisions?

Households choose a consumption path that maximizes lifetime utility subject to their budget constraint.

What is the role of preferences in the intertemporal model?

Preferences over present and future consumption influence household decisions and the overall economy.

What is the effect of a larger trade deficit in period 1?

It requires generating a larger trade surplus in period 2 to pay back additional debt acquired.

How does the model explain the behavior of identical households in a small open economy?

Studying one household's behavior reflects the behavior of the entire country.