Chapter 6 - Uncertainty and the Current Account

What is the Great Moderation?

A period of reduced volatility in the U.S. economy starting in the early 1980s.

When did the Great Moderation begin?

In the early 1980s, specifically post-1984.

What significant economic trend coincided with the Great Moderation?

The emergence of large U.S. current account deficits.

How did the volatility of U.S. output change after 1984?

It declined significantly, becoming much smoother.

What was the standard deviation of real GDP per capita growth before 1984?

1.2 percent.

What was the standard deviation of real GDP per capita growth after 1984?

0.6 percent.

What are the three explanations for the Great Moderation?

Good luck, good policy, and structural change.

What does the Good-Luck Hypothesis suggest?

The U.S. economy experienced smaller shocks by chance starting in the early 1980s.

What role did the Volcker Fed play in the Great Moderation?

It implemented aggressive low inflation policies.

What was Regulation Q (Reg Q)?

A regulation that imposed a ceiling on the interest rate banks could pay on deposits.

How did the abandonment of Regulation Q affect the economy?

It reduced financial distortions that exacerbated with inflation.

What does the Structural Change Hypothesis argue?

Technological developments in inventory management and finance led to smoother production and reduced business cycle amplitude.

What was the average current account balance as a percentage of GDP from 1947Q1 to 1983Q4?

0.34 percent.

What was the average current account deficit as a percentage of GDP from 1984Q1 to 2017Q4?

-2.8 percent.

What is the relationship between the Great Moderation and current account deficits?

The emergence of persistent current account deficits coincided with the beginning of the Great Moderation.

What is a commonly used measure of volatility in macroeconomic data?

The standard deviation.

What is the motivation question regarding the Great Moderation?

Is there a causal relation linking the Great Moderation with the emergence of current account deficits?

What is the intuition behind precautionary saving in an uncertain income environment?

Households are likely to save more to hedge against potential bad income realizations.

What happens to consumption in period 1 when households face uncertainty in period 2?

Consumption is likely to fall in period 1.

What must happen to the trade balance if consumption falls in period 1?

The trade balance must improve.

What is the implication of the decline in income uncertainty during the Great Moderation?

It should lead to an elevation in current account deficits.

What are the assumptions of an economy without uncertainty?

Endowments Q1 = Q2 = Q, utility function is ln C1 + ln C2, zero initial assets (B0 = 0), and zero interest rate (r* = 0).

What is the intertemporal budget constraint in an economy without uncertainty?

C1 + C2 = 2Q.

What is the first-order condition for maximizing utility in an economy without uncertainty?

1/C1 = 1/(2Q - C1).

What is the solution for consumption in period 1 (C1) under certainty?

C1 = Q.

What happens to consumption when output is perfectly smooth?

Consumption is also perfectly smooth, with no need to use the current account to smooth consumption over time.

What is the mean-preserving increase in uncertainty regarding period-2 endowment?

Q2 = Q + σ with probability 1/2 and Q - σ with probability 1/2.

What does the parameter σ represent in the context of uncertainty?

It measures the degree of uncertainty.

What is the expected value of Q2 under uncertainty?

E(Q2) = Q.

How is the variance of Q2 calculated?

Variance of Q2 = σ².

What are the two state-contingent intertemporal budget constraints for C2?

C2 = 2Q + σ - C1 (good state) and C2 = 2Q - σ - C1 (bad state).

What does the expected utility function look like?

ln C1 + E ln C2.

What is the household's maximization problem under uncertainty?

Choose C1 to maximize ln C1 + 1/2 ln(2Q + σ - C1) + 1/2 ln(2Q - σ - C1).

What is the first-order optimality condition for the household's problem?

u'(C1) = E(u'(C2)).

What does precautionary saving refer to?

An increase in saving due to uncertainty, leading to lower consumption.

How does an increase in uncertainty affect consumption and saving?

It induces a fall in consumption and an increase in saving.

What does a steeper marginal utility curve indicate regarding precautionary savings?

It shows that the higher the curvature of the utility function, the stronger the precautionary savings motive.

What is the relationship between uncertainty and the trade balance?

An increase in uncertainty causes an improvement in the trade balance and the current account.

What does the Great Moderation refer to?

A period starting in 1984 characterized by lower output growth volatility.

What are the three main explanations for the Great Moderation?

Good luck, good policy, and structural change.

What is the predicted effect of a mean-preserving increase in uncertainty on the current account?

It leads to an improvement in the trade balance and the current account.

What happens to the current account when output volatility decreases?

It contributes to the observed concurrent deterioration of the U.S. current account.

What is the significance of complete asset markets in relation to uncertainty and the current account?

With complete asset markets, the positive relationship between the level of uncertainty and the current account disappears.