International Macroeconomics: Slides For Chapter 6: External Adjustment in Small and Large Economies

Slides for Chapter 6:
External Adjustment in Small and Large Economies
International Macroeconomics
Schmitt-Grohé Uribe Woodford
Columbia University
May 1, 2016
1
International Macroeconomics, Chapter 6 Schmitt-Grohé, Uribe, Woodford
A Graphical Approach to Studying External Adjustment in

Small and Large Economies
We will derive a current account schedule: CAt = CA(rt; . . . ). This

will be helpful to analyze adjustment in the current account to
macroeconomic disturbances.
2
Recall the Investment Schedule from Chapter 5:
I1 = I( r1; A2, . . . )
− +
r1
← I(r1 ; A2 )
I1
3
Shifter of the Investment Schedule
• A2 ↑, then schedule shifts up and to the right
4
Introduce the Savings Schedule Results of Chapters 3 and 5 imply...
S1 = S( r1; Q1 Q2, . . . )
+ + −
r1
S1 (r1 ; Q1 , Q2 )
5
Shifters of the Savings Schedule
• Q1 ↑, S(r) shifts right.
• Q2 ↑, S(r) shifts left.
6
The Current Account Schedule
CA = S − I
CA(r) = S(r) − I(r)
7
Draw the savings and investment schedule in the same graph:
Given r, horizontal difference gives: S − I, which is the current

account.
r (a) (b)
1 r
1
S(r , Q )
1 1 CA(r )
a 1
a r
r
c
c r
r
b
b r
r
I(r )
1
S, I 0 CA
8
Current Account Determination in a Small Open

Economy
small ⇔ r = r∗, with r∗, the world interest rate given.
r1
CA1 (r1 ; . . .)
A
r ∗ r∗ , world interest rate
CA(r∗ ) 0 CA1
9
Now use the graphical apparatus to analyze current account adjustment

to:
1. An increase in the world interest rate, r∗ ↑.
2. A temporary output shock, Q1 ↑.
3. A future productivity shock, A2 ↑.
4. Expected future terms of trade depreciation.
10
1.) Current account adjustment to an increase in the world

interest rate
r1
CA(r1, Q1)
r*1
r*o
CA0 CA10 CA
11
2.) Current account adjustment to a temporary increase in

output
r1 (a) (b)
r
1
I(r1) S(r1, Q01) S(r1, Q11)
CA(r1, Q01)
CA(r1, Q11)
o
rc
1
rc
r* r*
So1 S11 Io1 S, I CAo1 CA11 0 CA
12
3.) Current account adjustment to a future increase in productivity

r1 (a) (b)
r
1
Io(r ) I1(r ) S1(r , Q ) CA1(r1, Q1)
1 1 1
o
1
CAo(r , Q )
1 1
S (r , Q )
1 1
r1
c
ro
c
* *
r r
1
S1 S1
o o
I1
1
I1 S, I CA1 CAo 0 CA
1 1
13
4.) Expected future terms of trade depreciation.

r1 (a) (b)
r1
I(r ) S(r , Q0) S(r , Q1)
1 1 1 1 1
CA(r , Q0)
1 1
CA(r , Q1)
1 1
roc
1
rc
r* r*
So S1 Io S, I CAo CA1 0 CA
1 1 1 1 1
14
Current Account Determination in a
Small Open Economy with
an Interest Rate Risk Premium
15
r1 = country interest rate
r∗ = world interest rate
Typically, r1 >> r ∗ for emerging market debtors. Why? Because of

positive country risk premia.
p ≡ r1 − r∗ = country risk premium
or
(
r∗ + p if country is a debtor
r1 =
r∗ if country is a creditor
16
Current account determination in the presence of a constant risk

premium
r1
CA(r1, Q1)
r*+p
*
r
CAo 0 CA
17
Current account determination in the presence of an increasing risk

premium
r
1
CA1(r1, Q1) CAo(r1, Q1)
*
r +p(−CA)
r*
CA11 CA01 0 CA
18
Equilibrium in a Large Open Economy
large → r 6= r∗.
Instead r is such that
CA(r) + CAROW (r) = 0
ROW = rest of the world
19
Current account determination in a large open economy
r
US′
RW CA US
CA CA
D′
B D
C A
CARW 0 CAUS
20
Bernanke’s Global Saving Glut Hypothesis
Ben S. Bernanke, “The Global Saving Glut and the U.S. Current
Account Deficit,” Homer Jones Lecture, St. Louis, Missouri, April
14, 2005.
21
Bernanke observes that between 1996 and 2004 the U.S. current
account has greatly deteriorated:
CA ($ bn) CA/GDP (in %)
1996 -125 -1.5
2000 -411 -4.0
2004 -634 -5.2
Note. These numbers differ slightly from those reported in Bernanke’s speech, because the
numbers in the table are revised numbers from the March 19, 2015 release.
22
Current Account Deterioration in Nominal Terms

100
1996 → ← 2004
−100
−200
Billions of Dollar
−300
−400
−500
−600
−700
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year
Data Source: Bureau of Economic Analysis.
23
While not quite as dramatic as in nominal terms, current account

deterioration also large in real terms ...
2
1996 → ← 2004
−1
Percent of GDP
−2
−3
−4
−5
−6
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year
Data Source: Bureau of Economic Analysis.
24
Bernanke then asks what accounts for this dramatic CA deterioration.
He suggests two alternative explanations:
• Hypothesis 1: (“Made in the U.S.A.”) The CA deterioration

primarily reflects developments inside the United States and is independent
of developments in other parts of the world.
• Hypothesis 2: (Global Saving Glut) The CA deterioration was due

to external factors, that is, due to developments in the rest of the
world (and hence not under U.S. control).
25
“Made in the U.S.A.” Hypothesis
The U.S. decided to save less and invest more ⇒ U.S. current
account schedule shifts up and to the left.
Why? Financial innovation induced low private savings rates and

over-investment in residential housing.
Global Saving Glut Hypothesis:
Over the past decade there was a significant increase in the global
supply of savings— a global saving glut ⇒ current account schedule
of the rest of the world shifts down and left
Why? (1) Emerging markets are accumulating foreign reserves to

prepare for future crises and avoid the experience of the 1990s. (2)
Export-led growth (brought about via exchange rate manipulation
— undervalued currency). (3) Foreign (developed) countries are
saving more in preparation for an aging population.
26
The “Made in the U.S.A.” Hypothesis versus Global Saving Glut Hypothesis
“Made in the U.S.A.” Hypothesis Global Saving Glut Hypothesis

r RW0 r
CAU S0 (r) CA (r)
CARW (r)
CARW (r) CAU S (r)
B CAU S (r)
r∗1
A
r∗o
A B
r∗o r∗1
o o
CARW CAU S
1
0 CAU S CAU S CARW CAU S
1
0 CAU S CAU S
27
How can we tell the Global Saving Glut Hypothesis and the
“Made in the U.S.A.” Hypothesis apart?
Both hypothesis imply that the U.S. current account deteriorates.
BUT
the global savings glut hypothesis predicts that interest rates fall
whereas the “Made in the U.S.A.” hypothesis predicts that interest
rates rise.
So we can use the observed behavior of interest rates to tell the two
hypotheses apart.
28
How to construct the real interest rate?
rt = real rate between period t and t + 1
it = nominal interest rate between t and t + 1
πt+1 ≡ Pt+1/Pt = gross rate of inflation between t and t + 1
Et = expectations operator conditional on information in period t
Use the Fisher equation,

(1 + it )
1 + rt = ,
Et πt+1
which says that the real rate equals the nominal rate minus expected
inflation.
it measured by 1-year Treasury rate.

29
πt measured by annual CPI inflation rate.
How to measure expected inflation, Et πt+1 ? We assume that πt+1 =

Et πt+1 for simplicity.
Alternatively, one could run a regression of 1/πt on its own lags.

The World Real Interest Rate: 1994-2004

4
1996 → ← 2004
2
Percent per year
−1
−2
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Year
Note. The world real interest rate is approximated by the difference between the rate on 1-year U.S. Treasury securities and 1-year ex post CPI inflation.
30
The World Real Interest Rate: 1992-2012

4
3
Percent per year
−1
1995 2000 2005 2010
Year
Note. The world real interest rate is approximated by the difference between the rate on 10-year U.S. Treasury securities and 10-year expected inflation.
30
The figure shows that real interest rates fell, which is consistent
with the Global Savings Glut Hypothesis and inconsistent with the
“Made in the U.S.A.” hypothesis.
31
Finally, can the Saving Glut Hypothesis be used to rationalize the

improvement in the U.S. current account after 2006? The argument
would go as follows. After 2006 the rest of the world decided to
save less and invest more, hence the CA schedule of the ROW
would have shifted up and to the right. As a result the CA balance
of the U.S. would have improved. What would have happened to
interest rates? They should have gone up. However, this is not what
happened, interest rates fell even further during the Great Recession,
suggesting that a subsiding of the savings glut is not the reason for
the improvement in the U.S. current account post 2006.
32

International Macroeconomics: Slides For Chapter 6: External Adjustment in Small and Large Economies

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International Macroeconomics: Slides For Chapter 6: External Adjustment in Small and Large Economies

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Slides for Chapter 6:

External Adjustment in Small and Large Economies

Schmitt-Grohé Uribe Woodford

A Graphical Approach to Studying External Adjustment in

We will derive a current account schedule: CAt = CA(rt; . . . ). This

Recall the Investment Schedule from Chapter 5:

Shifter of the Investment Schedule

• A2 ↑, then schedule shifts up and to the right

Introduce the Savings Schedule Results of Chapters 3 and 5 imply...

Shifters of the Savings Schedule

• Q1 ↑, S(r) shifts right.

• Q2 ↑, S(r) shifts left.

The Current Account Schedule

CA(r) = S(r) − I(r)

Draw the savings and investment schedule in the same graph:

Given r, horizontal difference gives: S − I, which is the current

Current Account Determination in a Small Open

small ⇔ r = r∗, with r∗, the world interest rate given.

Now use the graphical apparatus to analyze current account adjustment

1. An increase in the world interest rate, r∗ ↑.

2. A temporary output shock, Q1 ↑.

3. A future productivity shock, A2 ↑.

4. Expected future terms of trade depreciation.

1.) Current account adjustment to an increase in the world

2.) Current account adjustment to a temporary increase in

So1 S11 Io1 S, I CAo1 CA11 0 CA

3.) Current account adjustment to a future increase in productivity

4.) Expected future terms of trade depreciation.

Current Account Determination in a

Small Open Economy with

an Interest Rate Risk Premium

r1 = country interest rate

r∗ = world interest rate

Typically, r1 >> r ∗ for emerging market debtors. Why? Because of

p ≡ r1 − r∗ = country risk premium

Current account determination in the presence of a constant risk

Current account determination in the presence of an increasing risk

CA1(r1, Q1) CAo(r1, Q1)

Equilibrium in a Large Open Economy

Instead r is such that

CA(r) + CAROW (r) = 0

ROW = rest of the world

Current account determination in a large open economy

Bernanke’s Global Saving Glut Hypothesis

Current Account Deterioration in Nominal Terms

Data Source: Bureau of Economic Analysis.

While not quite as dramatic as in nominal terms, current account

Data Source: Bureau of Economic Analysis.

Bernanke then asks what accounts for this dramatic CA deterioration.

He suggests two alternative explanations:

• Hypothesis 1: (“Made in the U.S.A.”) The CA deterioration

• Hypothesis 2: (Global Saving Glut) The CA deterioration was due

“Made in the U.S.A.” Hypothesis

Why? Financial innovation induced low private savings rates and

Global Saving Glut Hypothesis:

Why? (1) Emerging markets are accumulating foreign reserves to

“Made in the U.S.A.” Hypothesis Global Saving Glut Hypothesis

Both hypothesis imply that the U.S. current account deteriorates.

How to construct the real interest rate?

rt = real rate between period t and t + 1

it = nominal interest rate between t and t + 1

πt+1 ≡ Pt+1/Pt = gross rate of inflation between t and t + 1

Et = expectations operator conditional on information in period t