Eco 344----Slide 3

After Midterm Exam 2

Chapter 6: Gain from Financial Globalization

• Why does individual person saves or borrows?• Essentially, saving in good times and

borrowing in bad times allow person to smooth consumption

• One gain of financial globalization is to allowing a country to smooth consumption

Borrowing Constraint

• A person must pay off his debt before he dies• This is called No-Ponzi Game condition• For a country, No-Ponzi game condition

guarantees that the country must service its debt and must not allow debt to roll over and grow without limit

• Long-Run Budget Constraint (LRBC) is the mathematical formulation of No-Ponzi game condition

Present Value

• Suppose you will earn 1 dollar one year later• The future value of this earning is 1 dollar• The present value of this earning is 1/(1+i)

dollar, where i denotes nominal interest rate• In general, the present value (PV) of X dollars

earned in Q periods later can be solved from the equation:

PV(1+i)Q =X

Remarks

• Future value and present value differ because money can earn interest

• Money earns interest because people need to be compensated for delaying consumption

Warm Up

• Wealth (W) is Stock• Borrowing (TB<0), Lending (TB>0), capital

gains and interest payment (W) are Flows• Change of stock is flow

Two-Period (N=0, 1) LRBC

• (No Ponzi-Game)• (Future Value Form of LRBC)• (Present Value Form of LRBC)

Remarks

• Positive initial wealth (>0) allows a country to borrow (TB<0) in both periods

• The total amount of borrowing is limited, in the PV sense.

• Given zero initial wealth, TB must have opposite signs in the two periods

General (N>1) LRBC

• The minus PV of initial wealth must equal the PV of trade balance, see equation (6-1)

• Equivalently, the PV of GDP (income) plus the PV of initial wealth must equal the PV of GNE (expenditure), see equation (6-3)

Application: Favorable Situation of US

• How to modify LRBC for US• Why is it a bad idea to default US debt?• Why is it important to maintain the status of

reserve currency for US dollar?• Why does the government want to protect

Wall Street?

Application: Difficult Situations of Emerging Markets

• How to modify LRBC for Thailand• Why does emerging-market country want to

keep foreign reserve?• Why does emerging-market country hate

Soros?

US Debt

• http://www.bbc.co.uk/news/business-14760684

• http://www.bbc.co.uk/news/business-14204527

A Model of Smoothing Consumption

Monetary Policy

• Monetary policy is effective if it can change the interest rate and if the total demand responds to the change in the interest rate.

• There are three scenarios in which monetary policy becomes ineffective

Scenario One: Irresponsive Demand

• Vertical IS curve • Expansionary monetary policy can cause

interest rate to fall, but total demand is irresponsive to falling interest rate.

• This can happen when firms and individuals have very bad expectation for future economy.

Scenario Two: Liquidity Trap

• Liquidity trap occurs when nominal interest rate equals zero

• Increasing money supply cannot cause interest rate to go down further

• Real interest rate can be high due to deflation • Investment and consumption remain low due

to high real interest rate• http://en.wikipedia.org/wiki/Liquidity_trap

Scenario Three: Fixed Exchange Rate

• Increasing money supply causes interest rate goes down, and exchange rate to go up

• To maintain peg, central bank intervenes the FX market by buying domestic currency and sell foreign reserve

• The intervene causes money supply to go back to its original level

• So fixed exchange rate plus capital mobility forces a country to give up autonomous monetary policy (Trilemma).

Fiscal Policy

• Increasing government expenditure shifts IS line up, causing interest rate and output to rise

• Rising interest rate crowds out investment and export.

• Crowding out can be big if LM line is steep

Ricardian Equivalence

• Fiscal policy becomes ineffective if the rising government expenditure is totally offset by the falling personal consumption. People save more (and consume less) because they expect later government will rise tax to pay the expenditure. This is called Ricardian Equivalence.

Effective Fiscal Policy

• Fiscal policy can be very effective in two scenarios:

• (1) Liquidity Trap (there is no crowding out due to flat LM line).

• (2) Fixed exchange rate (the money supply automatically reinforces the effect of rising government expenditure)

Discuss: How to boost US economy

• How about expansionary monetary policy?• How about expansionary fiscal policy?• What kind of difficulties are we facing?