Chapter 4 - Terms of Trade, the World Interest Rate, Tariffs, and the Current Account

What are the three important shocks for open economies discussed in Chapter 4?

Terms of trade, world interest rate, and tariffs.

What is the definition of terms of trade?

The relative price of exports in terms of imports.

How is the terms of trade calculated in period 1?

TT1 = PX1 / PM1, where PX1 is the price of exports and PM1 is the price of imports.

If the price of oil is $90 per barrel and the price of wheat is $10 per bushel, what is the terms of trade?

The terms of trade is 9, meaning one barrel of oil can buy 9 bushels of wheat.

What does the intertemporal budget constraint represent?

It represents the relationship between consumption in different periods and the initial budget, adjusted for terms of trade.

What happens to the current account in response to positive terms-of-trade shocks?

The current account improves (increases).

What happens to consumption in response to permanent changes in terms of trade?

Consumption changes upwardly if the shock is positive and downwardly if it is negative, with little movement in the current account.

Why is it difficult to determine the nature of a shock (permanent or temporary)?

Agents must form expectations about the duration of the shock, which may not be validated by future developments.

What is the effect on the current account if households expect a temporary improvement in terms of trade?

The current account will improve in the period of the shock.

What is the effect on the current account if households anticipate a future terms of trade improvement?

The current account will deteriorate as households borrow against higher expected future income.

What was the main export product of Chile during the copper price boom of the early 2000s?

Copper, which accounted for more than 50% of exports.

What was the observed trend of copper prices from 2001 to 2013?

The price of copper more than tripled after being relatively stable for two decades.

What does the intertemporal theory of current account determination emphasize?

It emphasizes the expected path of income rather than just current income.

What is the relationship between terms-of-trade shocks and output shocks?

Terms-of-trade shocks are similar to output shocks in terms of their effects on consumption and the current account.

What does the term 'current account' refer to?

The current account reflects a country's transactions with the rest of the world, including trade in goods and services.

What is the significance of the transversality condition in the intertemporal budget constraint?

It implies that the budget constraint must account for future consumption without indefinite borrowing.

How do households adjust their consumption in response to terms-of-trade shocks?

They adjust consumption upwardly for positive shocks and downwardly for negative shocks.

What is the importance of expectations in the context of terms-of-trade shocks?

Expectations influence how households respond to shocks, affecting current account dynamics.

What does TT1Q1 represent in the budget constraint?

TT1Q1 represents the income from exports in terms of trade in period 1.

What does TT2Q2 represent in the budget constraint?

TT2Q2 represents the income from exports in terms of trade in period 2.

What is the effect of a positive terms-of-trade shock on household income?

Household income increases, leading to adjustments in consumption and the current account.

What does the term 'imperfect information' refer to in the context of economic shocks?

It refers to the uncertainty agents face regarding the duration and impact of economic shocks.

What was the trend in copper prices between 2003 and 2007?

Copper prices rose from 120 to over 350 cents and remained high until 2013.

What does the intertemporal theory of the current account predict about CA1 during periods of rising terms of trade?

CA1 should not have improved; it should have stayed the same or deteriorated.

What significant change occurred in Chile's current account from 2003 to 2007?

The current account improved from deficits of around 1% of GDP to surpluses of about 3% of GDP.

Why does the behavior of Chile's current account contradict the predictions of the intertemporal theory?

It contradicts because the theory assumes perfect foresight about the copper price, which was not the case.

What did Chilean economic experts predict about the copper price between 2005 and 2015?

They predicted the average copper price would be below 100 until 2007.

What happens to the current account when an improvement in terms of trade is expected to be temporary?

The current account should improve, which aligns with the observed behavior.

What are the two opposing effects of a change in world interest rates?

The substitution effect (higher interest rates increase saving) and the income effect (which can either increase or decrease consumption).

What is the substitution effect in relation to interest rates?

A higher interest rate makes bonds more attractive, leading to decreased consumption and increased saving.

What is the income effect when households are borrowing during an interest rate hike?

The income effect is negative, making households poorer, which leads to decreased consumption and increased saving.

What is the income effect when households are lending during an interest rate hike?

The income effect is positive, making households richer, which leads to increased consumption and decreased saving.

What is the adjustment to an increase in the world interest rate?

Period-1 consumption falls while period-2 consumption increases, improving the trade balance and current account.

How can an increase in import tariffs affect a country's trade balance?

It can have a positive, negative, or no effect depending on how current tariffs compare to expected future tariffs.

What happens if current import tariffs are higher than future tariffs?

Imports become relatively expensive, leading to a decrease in import demand and an improvement in the trade balance.

What is the effect of permanent import tariffs on consumption across time periods?

If tariffs are permanent, there is no reason to shift consumption, and the tariff will have no effect on the trade balance.

How can import tariffs be modeled in the context of two goods?

Assume one export good and one import good, with government rebates from tariff revenues to households.

What do the household budget constraints in periods 1 and 2 account for?

They account for consumption, terms of trade, lump sum transfers, and interest on borrowing.

What is the formula for the intertemporal budget constraint?

(1 + τ1)C1 + (1 + τ2)C2 / (1 + r1) = ˜Y

What does ˜Y represent in the intertemporal budget constraint?

Lifetime wealth, which includes initial wealth and income from various sources.

What is the household's maximization problem in this context?

Maximize U(C1) + βU(C2) subject to the intertemporal budget constraint.

What is the first-order condition associated with the household's maximization problem?

The Euler equation: β(1 + r1)U′(C2) = (1 + τ1)U′(C1) / (1 + τ2)

How does the government handle revenue from import tariffs?

The government rebates any revenue from the import tariff to households in a lump sum.

What is the government budget constraint in periods t = 1, 2?

Lt = τtCt, where Lt is the government revenue from tariffs.

What is the economy-wide resource constraint?

C1 + C2 / (1 + r∗) = (1 + r0)B0 + TT1Q1 + TT2Q2 / (1 + r∗)

What happens to the optimal consumption path when a temporary increase in import tariffs is imposed?

Period-1 consumption declines and the trade balance improves.

What is the effect of a permanent increase in import tariffs on the equilibrium consumption path?

It has no effect because the import tax rates cancel out of the Euler equation.

What occurs when agents anticipate a future increase in import tariffs?

Period-1 consumption increases, leading to a deterioration in the trade balance.

What are terms-of-trade shocks?

Changes in the relative price of export goods in terms of import goods.

How do interest rate shocks affect consumption?

They have both substitution and income effects, influencing current consumption and savings.

What is the substitution effect of an increase in interest rates?

It discourages current consumption and incentivizes savings, improving the current account.

What happens to borrowers when interest rates increase?

They experience a negative income effect, making them poorer and reducing consumption.

What happens to lenders when interest rates increase?

They experience a positive income effect, leading to higher consumption.

What is the overall effect of temporary import tariffs on the trade balance?

They can lead to an improvement in the trade balance.

What is the effect of anticipated future import tariffs on the trade balance?

They can lead to a deterioration in the trade balance.

What is the conclusion regarding permanent changes in tariffs and the trade balance?

They leave the trade balance unchanged.

What is the implication of import tariffs in the current framework?

Import tariffs are welfare decreasing.

What does the term 'welfare reducing' imply in the context of tariffs?

It suggests that tariffs decrease overall economic well-being.

What is the relationship between the intertemporal resource constraint and optimal consumption paths?

Changes in tariffs do not alter the intertemporal resource constraint but affect consumption paths.

What is the significance of the Euler equation in this economic model?

It establishes the relationship between current and future marginal utilities of consumption.

What does the notation TT1Q1 represent?

It refers to the total trade quantity in period 1.

What does the notation (1 + r0)B0 represent?

It represents the initial wealth adjusted for the interest rate.