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Week 4 (Chap 6: Balance of Payments Part 1 (6.3: Gains from Efficient…

- - - - the limit to how much a nation can borrow in the long run. The LRBC tells us precisely how and why a country must, in the long run, “live within its means.
      - The country is a small open economy. The country trades goods and services with the rest of the world through exports and imports and can lend or borrow overseas, but only by issuing or buying debt (bonds). Because it is small, the country cannot influence prices in world markets for goods and services.
      - All debt carries a real interest rate r*, the world real interest rate, which we assume to be constant. Because the country is small, it takes the world real interest rate as given, and we assume the country can lend or borrow an unlimited amount at this interest rate.
  - - - A closed economy, in which TB = 0 in all periods, external borrowing and lending are not possible, and the LRBC is automatically satisfied
      - An open economy, in which TB does not have to be zero, borrowing and lending are possible, and we must verify that the LRBC is satisfied
    - - Households, which consume, are identical. This means we can think of a representative household, and use the terms “household” and “country” interchangeably. The country/household prefers a level of consumption C that is constant over time, or smooth. This level of smooth consumption must be consistent with the country/household’s LRBC.
      - To keep the rest of the model simple—for now—we assume that consumption is the only source of demand, and that both investment I and government spending G are zero. Under these assumptions, GNE equals personal consumption expenditures C. In this simple case, if the country is open, the trade balance (GDP minus GNE) equals Q minus C. The trade balance is positive (negative) only if Q, output, is greater (less) than consumption C.
      - The economy’s GDP or output is denoted Q. It is produced each period using labor as the only input. Production of GDP may be subject to shocks; depending on the shock, the same amount of labor input may yield different amounts of output.
      - Our analysis begins at time 0, and we assume the country begins with zero initial wealth inherited from the past, so that W−1 is zero.
        When the economy is open, we look at its interaction with the rest of the world (ROW). We assume that the country is small, ROW is large, and the prevailing world real interest rate is constant at r. In the numerical examples that follow, we assume r = 0.05 = 5% per year.
  - - - A closed economy, in which external borrowing and lending are not possible, the trade balance is zero in all periods, and the LRBC is automatically satisfied
        An open economy, in which borrowing and lending are possible, the trade balance can be more or less than zero, and we must verify that the LRBC is satisfied
      - The LRBC will hold if and only if the present value of output Q equals the present value of expenditure (C + I).
    - - Firms will take on investment projects as long as the marginal product of capital (MPK) is at least as great as the real interest rate.
    - - Let’s start with a country that has output of 100, consumption (C) of 100, no investment (I), a zero trade balance, and zero external wealth. If that state persisted, the LRBC would be satisfied, just as it was in the prior numerical example with consumption smoothing. This outcome describes the optimal path of consumption in both the closed and open economies when output is constant and there are no shocks; that is, nothing happens here that makes the country want to alter its output and consumption.
      - Firms will take on investment projects as long as the marginal product of capital (MPK) is at least as great as the real interest rate.
  - - - With diversification, countries own not only the income stream from their own capital stock, but also income streams from capital stocks located in other countries.
    - - To generalize this result to the real world, we need to recognize that not all shocks are asymmetric as we have assumed here.
      - In the real world, any one country experiences some shocks that are correlated with those of other countries, either positively or negatively, and some that are uncorrelated. As long as some shocks are asymmetric, or country specific, and not common between the home and foreign country, then the two countries can take advantage of gains from the diversification of risk.