Tahmina Miah

Intertemporal Trade and the Current Account Balance

-With the aid of loans from foreigners, an economy with a temporary shortfall can avoid a
sharp contraction of consumption and investment. Similarly a country with ample savings can
lend and participate in productive investment projects overseas.
-Resource exchanges across time are called intertemporal trade, measured by the current
account of the balance of payments.
-Objective: Illustrate some economic principles that govern intertemporal trade i.e.
>When are countries foreign borrowers?
>When do they lend abroad?
>What are the welfare implications of international capital market integration?

1.1 A Small Two-period Endowment Economy

2 period model of saving (Irving Fisher 1930)
Assume that:
-Small open economy which takes the world interest rate as given
-Consumes single good
-2 periods
No uncertainty (perfect foresight) and no frictions.

1.1.1 Consumers Problem
Individual maximizes the present discounted value of his lifetime utility which depends on
period consumption levels denoted by

:
(1)
) ( ) (
2 1 1
i i i
c u c u U | + = , 1 0 < < | , 0 ' ' , 0 ' < > u u

In this equation is a fixed preference parameter, called the subjective discount factor that
measures the individuals impatience to consume.
Assume that the period utility function is strictly increasing and strictly concave so that:
()>0 ; ()<0

Life time budget constraint

(2)
r
y
y
r
c
c
i
i
i
i
+
+ =
+
+
1 1
2
1
2
1


Y denotes individuals output, r real r=interest rate in the world capital market on date 1.
Consumption must be chosen subject to the lifetime budget constraint. This constraint
restricts the present value of consumption spending to equal the present value of output.
Output perishable so Y
1
cannot be stored.

Assume perfect foresight
Solve problem of maximizing eq.1 subject to eq.2 by substituting for

As such, the optimization problem reduces to the following equation:
i
c
Max
1
] ) )( 1 [( ) (
2 1 1 1
i i i i
y c y r u c u + + + |
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Intertemporal Euler equation
The FOC for this problem is:
(3)
) ( ' ) 1 ( ) ( '
2 1
i i
c u r c u | + =

This is called the Intertemporal Euler equation. This equation simply says that in order for the
individual to be in an optimum position (subject to his budget constraint) it is necessary that
he should not gain from feasible shifts of consumption between period 1 and period 2. The
Euler equation thus states that at an optimum these 2 quantities are equal. The Euler equation
(3) can also be written as:

(4)
r c u
c u
i
i
+
=
1
1
) ( '
) ( '
1
2
|


The LHS is the consumers MRS of present for future consumption.
The RHS is the price of future consumption in terms of present consumption.

If =1/1+r, so that the subjective discount factor = the market discount factor, then

i i i i
c c c u c u
2 1 2 1
) ( ' ) ( ' = =

This implies that the consumer desires a flat lifetime consumption path. Budget constraint
eq.2 then implies that consumption in both periods is c
i
:

(5)

1.1.2 Equilibrium of the Small Open economy
Assume:
-All individuals in the economy are identical
-Population size is 1

Allows us to drop subscript i, so C stands for aggregate consumption, Y for aggregate output.
We assume the national aggregate quantities are equilibrium quantities (homogeneous
population of size 1). Consequently, we can rewrite equation (5) above as:

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If =1/1+r, so that the subjective discount factor = the market discount factor, the time path of
aggregate consumption is flat. Other things the same, countries will wish to smooth their
consumption when subjective discount factor the market discount factor.

a. if
r +
=
1
1
| , then consumption smoothing
b. if

but C
1
+C
2
. The world capital market offers the country a rate of return that more
than compensates it for the postponement of a little more consumption. Consumption-tilting
to the 2
nd
period, according to Euler equation ) ( ' ) ( '
2 1
c u c u > ,
2 1
c c <

1.1.3 International Borrowing and Lending, the Current Account, and the Gains from
Trade

>Because international borrowing/lending is possible, there is no reason for an open
economys consumption to be closely tied to its current output. If =1/1+r, consumption is
flat at the level C
1
=C
2
=C* but output need not be. Suppose that
1
<
2
the country can borrow

1
from foreigners on date 1 and repay (
1
) (1+r) on date 2. On date 2, consumption
will be:
2
=
2
(
1
) (1+r). Obviously the intertemporal budget constraint holds true.
>A countrys current account balance over a period is defined as the change in the countrys
net foreign assets. The CA is said to be in surplus if positive, so that the economy as a whole
is lending and in deficit if negative so that the economy is borrowing.
>Note that the capital account surplus preceded by a minus sign equals the current account
balance.
> B
t+1
value of the economys net foreign assets at the end of a period t.

The CA balance is:
(6)
t t t t t t t
C B r Y B B CA + = =
+1

r
t
B
t
: interest earned on foreign assets acquired previously
GDP= Y
t

GNP = the value of the final output produced within its border + net international factor
payments =
t t t
B r Y +
CA surplus i.e.

>0 means that a country saves more than it consumes, there is a capital
outflow and exports exceed imports.

The Current Account and the Budget Constraint in the Two-Period Model
In the two period model that we analysed, initial and terminal wealth is zero i.e.
(7)
1
=
3
=0.

3
=0 means that the economy ends period 2 holding no uncollected claims on foreigners
(foreigners do not wish to expire holding uncollected claims on the home country either). The
above equalities have implications for each periods current account. Consequently, in period
1 the current account will be:
(8)
1
=
1

1
=
2

Equation (8) along with equation (2) the current account in period 2 can be written as:

(9)
2
=
2
+
2

2
=
2
+ (
1

1
)
2

=
2
+
2

2
=
2
+ (
1

1
) 2
=
1

1
=
1
=
2


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Equations (8) and (9) imply that the present CA deficit (surplus) must be matched with future
CA surplus (deficit).

As a result, the countrys cumulative current account balance in a two period model with zero
initial and terminal assets is expressed as:
(10) 0
1 3 2 3 1 2 2 1
= = + = + B B B B B B CA CA
(From eq. 7)

(Figure 1.1) combines individuals indifference curves, IC with the intertemporal budget
constraint, BC (eq.2). Optimal point C, where BC is tangent to the highest IC.


>The 1
st
period CA balance is the distance between Y1 (output) and C1 (consumption)
points.
>An unbalanced current account is not necessarily a bad thing. The country does it better by
running an unbalanced current account in both periods than it would if forced to be at the
autarky point A forced to set
1
=
1
and
2
=
2
.
>The utility gain between points A and C illustrates the general and classic insight that
countries gain from trade.

1.1.4 Autarky Interest Rates and the Intertemporal Trade Pattern

In autarky countries cannot lend and borrow from abroad, thus

for every t.
Define the autarky interest rate

as the interest rate that achieves the same consumption

profile as autarky. In other words the Euler equation (3/4) must still hold with outputs
replacing consumptions:

(11)

=
A
r Y u
Y u
+
=
1
1
) ( '
) ( '
1
2
|


*If
A
r r < => future consumption is relative cheap in home country, current consumption
relatively expensive. Home country will import present consumption from abroad in the 1
st

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period by running a CA deficit and export future consumption later (by repaying its foreign
debt) (Principle of comparative advantage: import those commodities whose autarky prices
are high compared with world prices and export those whose autarky prices are
comparatively low.)
*If
A
r r > => CA surplus in the 1
st
period. A rise in Y
1
or fall in Y
2
lowers r
A
, since

with
either event at the previous r
A
residents save more lend more, so r
A
falls. An increase in
also causes r
A
to fall.

*Gap bigger between r and
A
r , trade gain is bigger.
*If
A
r r = => no gain.

1.1.6 Adding Government Consumption

>Suppose government consumption per capita, G, with a balanced budget, and utility
function is additive, ) ( ) ( G v C u + .
>Lifetime utility now becomes:
1
= u
1
+v(
1
)+[u2+v
2
] (from eq.1)
>Suppose that the government runs a balanced budget every period, i.e. taxes
1
=
1
and

2
=
2
.
>Budget constraint becomes:

(12)
r
G Y
G Y
r
C
C
+

+ =
+
+
1 1
2 2
1 1
2
1
(From eq.2)


>Current account becomes:
(13)
t t t t t t t t
G C B r Y B B CA + = =
+1
(From eq.6)

>The intuition here is that both government and private consumption are subtracted from
national income in order to compute the current account.
>Introducing government consumption is equivalent as expressing the private sectors
endowment Y as output net of government consumption, i.e. Y-G.
>Given that the utility from government consumption enters additively into the utility
function, the Euler equation (3) remains valid.

How do government consumption decisions affect the current account?
>Assume
r +
=
1
1
| = and output is constant, Y Y Y = =
2 1

>In the absence of government consumption, private consumption would be constant at =
with the current account being balanced.
>Suppose however that 1>0 and 2=0. The private sector will want to borrow against its
relatively high second period after tax income to shift part of the burden of the temporary
taxes to the future. As a result, the country will run deficit in period 1 and a surplus in period
2.
> Replacing Y with Y-G in equation (5) implies that:

(14)
r
G r
Y
r
Y G Y r
C
+
+
=
+
+ +
=
2
) 1 (
2
] ) )( 1 [(
1 1

>Government consumption in period 1 lowers private consumption, but by an amount smaller
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than
1
G . Reason being that G drops to 0 in period 2.
>Since B=0, the Current account implies:

(15)
0
2
1
1 1
<
+
= =
r
G
G C Y CA
(From eq.8)


>Temporary increases of government expenditures leads to CA deficit in a small open
economy. However, this also depends on global issues related to other countries willingness
to lend.
>If G G G = =
2 1
, then consumption is constant ( ) G Y C = and CA is always balanced.

1.2.1 The Role of Investment
>So far CA = national saving. In general, CA = S I.
>I usually is much more volatile than saving, to ignore investment is to miss much of the
action.
>Assume that output is produced using capital, which in turn, can be accumulated through
investment. The production function for new output in each period is given by:
(16)
) (K F Y =

>Assume that >0, <0, 0=0.
>In addition, it is assumed that labour is supplied inelastically by the individual producer.
Capital and consumption are assumed to be homogeneous.
>Capital evolves according to the law of motion:
(17)
+1
=

+

>Total private wealth at the end of period t is now
1 1 + +
+
t t
K B . The sum of net foreign assets
and the stock of domestic capital. The change in total domestic wealth, national saving is:
(18)
t t t t t t t t t
G C B r Y K B K B + = + +
+ +
) (
1 1


>The current account becomes:

Rearrange:

(19)
t t t t t t t t t
I G C B r Y B B CA + = =
+1


Define national savings as:
(20)
t t t t t t
G C B r Y S +

The current account in an economy with investment can be written as a saving-investment
identity:
(21)
t t t
I S CA =

Indicates that current account is an intertemporal phenomenon.

1.2.2 Budget Constraint and Individual Maximization
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Add the asset accumulation identities for periods 1 and 2 in order to derive the intertemporal
budget constraint when there is both government spending and investment.
From eq. 18 & 19:
- Given
1 1 1 1 2
I G C Y B = (recall ) 0
1
= B
- And
2 2 2 2 2 2
I G C rB Y B + =

(recall B
3
= 0)
Solve this for B
2
and then substitute:

Budget constraint:

(22)
r
G Y
G Y
r
I C
I C
+

+ =
+
+
+ +
1 1
2 2
1 1
2 2
1 1


Now it is the present value of consumption plus investment that is limited by the present
value of output.

>In this economy the individual maximizes the present discounted value of his lifetime utility

1
=u
1
+u
2
subject to equation (22) above, where equation (16) replaces Y with F(K) and
equation (17) is used to replace with the change in K (law of motion of capital),
+1
=

+
.

>K
2
accumulated in period 1 will be consumed at the end of period 2 and K
3
will be zero,
implying that:
(23)
2 2 2 3 2
0 K K K K I = = =

>As a result, the consumer solves:
Max ) ( ) (
2 1 1
C u C u U | + = => using (21) to eliminate
2
C
r
G Y
G Y
r
I C
I C
+

+ =
+
+
+ +
1 1
2 2
1 1
2 2
1 1

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(24)
} ) ( ] ) ( )[ 1 {( ) (
1 1 2 1 1 1 1 1 1 1
,
1 1
K I G K I F I G C K F r u C u Max
I C
+ + + + + + |
>K
1
given by history
2 FOCs are:
a. Euler equation: ) ( ' ) 1 ( ) ( '
2 1
C u r C u | + =
b. r K F = ) ( '
2
, Marginal return = return of foreign loan
>Where K
2
= K
1
+ I
1

>The marginal return on capital must be equal to the interest rate (consumers must be
indifferent between investing in local capital or foreign assets i.e.)

Investment determined only by domestic productivity and world interest rates is
independent of domestic consumption. (Fisher separation Hypothesis. Under the
assumptions: small open economy-Saving decision does not change the interest rate, only one
tradable good, free capital markets. Therefore, Government consumption doe not crowd out
investment either.)
The extended model allows for a motive for borrowing to invest and consume. Current
account is no longer procyclical. Any shock, which would increase both current income and
investment together, has the potential for leading to a fall in the CA if investment is great
enough.

1.2.3 Production Possibilities and Equilibrium

Lets assume temporarily that government consumption is zero in both periods.

To analyse graphically the determination of the current account, we need a production
possibility frontier (PPF) that shows the technological possibilities available in autarky. This
is given by the following equation:

1 1 1 1 1 1 2
) ( ] ) ( [ C K F K C K F K F C + + + = (25)


If the economy chose the
lowest possible investment
level on date 1 by eating all
its inherited capital
immediately (set
1
=
1
), it
would enjoy the highest date
1 consumption available in
autarky, i.e.
1
=
1
+ (
1
).

It this case date 2
consumption would be at its
lowest possible level,

2
=(0)+0=0. This is the PPF
horizontal intercept in figure
2 below.



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At the other extreme, the economy could invest all output on date 1 (eat no capital at all).
This decision would imply that:

1
=0

1
= (
1)

2
=
1
+ (
1
)

2
= F [
1
+(
1
)]+
1
+(
1
)
The last being the highest date 2 consumption available in autarky.


PPFs slope: )] ( ' 1 [
2
1
2
K F
dC
dC
+ =

Capitals diminishing marginal productivity makes the PPF strictly concave.

Figure 1.2

Point A (autarky point): PPF tangent to highest IC the economy can reach without trade.
Common slope of 2 curves at A is (1+

).

However, the economy faces a world interest rate () lower that the autarky rate at point
A.

Point B (trade allows to produce at this point). The opportunity to trade across periods with
foreigners lets domestic residents gain by investing more and producing at point B, through
which the economys budget line passes.

Point C, consumption point at point C gives the economy the highest utility it can afford

** Figure 1-1: trade gains due to the smoothing the time path of consumption.
**Figure 1-2: addition source of gain, change in production point (A->B).

*The horizontal distance between point A and B is the extra investment generated by opening
the economy to the world capital market.

*The horizontal distance between point A and C shows the extra first period consumption
that trade simultaneously allows.

*The distance from B to C is the first period current account deficit.

*The utility curve through point C lies above the one through point A. The distance between
them measures the gains from trade.