Question 1: Balance of Payments & International Investment Position

The ratio of the net international investment position to GDP evolves according to the dynamic equation:

Δb_t = b_t - b_t-1 = bgst_t + (r_t^L - g_t)/(1 + g_t)b_t-1 + r_t^A-r_t^L/(1+gt)a_t-1 + ∈_t

In the questions that follow, assume ∈_t = 0.

a) State algebraically the condition under which a country can run a trade deficit yet experience an improvement in its net foreign asset position. Explain the different factors that might generate this configuration.

b) Suppose the trade deficit is -0.05 and the inherited net foreign asset position from the end of period t - 1 is -0.20. The output growth rate is +0.03, the gross stock of foreign assets (as a fraction of GDP) at the end of period t - 1 is 1.20, the return on liabilities is +0.02 and the return on assets is +0.05. What is b_t? Interpret.

c) Consider the same conditions as in b) except that the country in question is now a creditor, with b_t-1 = +0.20. What is b_t? Interpret.

d) Suppose r_t^A = r_t^L = 0.04, g = 0.02, and b_t-1 = -0.50. What value of the trade balance is required in order to stabilise the net foreign asset position at b_t = -0.50?

e) Now suppose that r_t^A = r_t^L = 0.01, g = 0.02, and b_t-1 = -0.50. What value of the trade balance is required in order to stabilise the net foreign asset position at b_t = -0.50? Comment on the differences between the answers to parts d) and e).

f) Download Lane and Milesi-Ferretti's updated External Wealth of Nations II dataset. What were the NFA-CA (net foreign assets-current account) configurations for China, USA, Ireland and Malta in the year 2010 (e.g. country X had positive NFA and positive CA in year 2010.

Note that NFA is a stock variable reported at the end of the year, while CA is a flow variable). Comment on any two of these configurations. Using your knowledge about Ireland, what impact is net factor income from abroad (NFIA) having on its current account position? Explain.

g) Write an essay (max. 1200 words) examining the trend in global external imbalances over the past 20 years. A significant part of your essay should be devoted to analysing the external adjustment phase during the global crisis.

Question 2: Consumption Smoothing in the Two-Period Model

Consider the two-period small open economy model, where preferences are given by:

U = C₁^1-ρ/(1-ρ) + β C₂^1-ρ/(1-ρ)

where ρ ≠ 1. The representative consumer receives endowments Y₁ and Y₂ in periods 1 and 2 respectively and can borrow and lend at the exogenously-given world interest rate r. For the questions that follow, please explain your answers.

a) What is the optimal relation between C₁ and C₂ in this environment?

b) Suppose that β(1 + r) = 1. If Y₁ = 90 and Y₂ = 40 , what is the optimal level of consumption in period 1? What is the value of the current account in period 1? (Note: your answers will be in terms of r.)

c) Under what condition will C₂ exceed C₁?

d) What is the role played by the intertemporal elasticity of substitution, 1/ρ, in determining the relation between C₁ and C₂?

Question 3: Fiscal Policy and the Current Account

Consider the two-period small open economy model, where preferences are given by:

U = C₁^1-ρ/(1-ρ) + 1/(1 + δ).C₂^1-ρ)/1-ρ

The representative consumer receives endowments Y₁ = Y₂ = Y in periods 1 and 2 respectively and can borrow and lend at the exogenously-given world interest rate r = δ, where δ is the rate of time preference (or discount rate). Government consumption equals G₁ and G₂ in periods 1 and 2 respectively. In answering the questions that follow, please ensure that explanations are provided (i.e. intuition).

a) Suppose that G₁ = G₂ = G‾₀. What is the optimal relation between C₁ and C₂ in this environment? What is the value of the current account in period 1?

b) Now suppose that there is a shift in planned government consumption such that G₁ = G₂ = G₁ < G₀‾. How do consumption and the current account respond to this shift in government consumption?

c) Now suppose that G₁ = G₀‾ and G₂ = G₁‾ (with G₁‾ < G₀‾ as in b)). How do consumption and the current account respond to this shift in government consumption?

Question 4: Savings and Investment in the Global Two-Country Model

Consider a world composed of two countries that are initially identical. The Home and Foreign production functions are

Y = AF(K) and Y* = A*F(K*)

a) Using a graphical analysis, show the qualitative response of the Home and Foreign current accounts and the world interest rate to an anticipated increase in the value of A(A* is unchanged). Explain the intuition for your answer.

b) Suppose rather that there is an anticipated global productivity boom, with the values of A and A* increasing by the same amounts. Again, using a graphical analysis, show the qualitative responses of Home and Foreign current accounts and the world interest rate in this case. Explain the intuition for your answer.

c) In contrast to being anticipated in the future, let's now assume that a Home productivity rise is observed today (no change in Foreign's productivity). Examine the responses in Home and Foreign current accounts and the world interest rate (use graphs).

d) Imagine that Home is now more impatient, represented by a higher rate of time preference δ (no change in Foreign's impatience). Examine the responses in Home and Foreign current accounts and the world interest rate (use graphs).

e) Using a graphical analysis, first explain the impact of an outward shift in the foreign country's saving schedule (that is, it wants to save more at any given interest rate). Next, explain the impact of an inward shift in the foreign country's investment schedule (that is, it wants to invest less at any given interest rate). Which scenario better captures the impact of emerging Asia on the world economy since the late 1990s? Discuss.

Question 5: Real Exchange Rates & the Balassa-Samuelson Model

a) Identify the key assumptions of the Balassa-Samuelson model discussed in lectures. Briefly outline the hypothesis it posits.

b) How could one augment the Balassa-Samuelson model such that the demand side also plays a role? In this case, explain three other factors that could potentially influence the real exchange rate in the long run.

c) Consider production functions across traded (T) and nontraded (N) sectors in home (h) and foreign (f) that are given by Y_i,T = A_i,TL_i,T and Y_i,N = A_i,NL_i,N where i ∈ {h, f}, Y is output, A is productivity, and L is labor. P_i,T and P_i,N denote output prices, while w_i,T and w_i,N denote wages.

Given this information, answer the following.

i) For each country, obtain an expression for the relative price of nontradables.

ii) Noting that the real exchange rate is defined as Q = SP_f/p_h, where P_h = P^α_h,T P^1-α_h,N and P_f = P^α_f,T P^1-α_f,N are aggregate prices, S is the nominal exchange rate, and P_h,T = P_f,T, examine the implications of the configuration A_h,T < A_f,T and A_h,N = Af,N for Q(relative to Q = 1)

Explain what happens when α = 1?