Professional Documents
Culture Documents
Foundations of International Macroeconomics PDF
Foundations of International Macroeconomics PDF
¢ (by the law of iterated conditional expectations) the preceding stochastic difference equation for output implies E,{¥—F} =p", - de G4) as you can check by iterated forward substitutions.?? Note that when G eq. (32) can be written G Bes tS (cL) “eth 19, The approximation view of eg, (32) rises two questions. Fist, what ensures that wealth does not randomly walk arbtsarly far from the approximation poin? Second. given the absence of a natural expected steady stale for wealth around which wealth level is an approximation to be taken? One answer comes from precautionary saving theory (see section 2.3.6). Clana (1990) proposes a geneal- xqlibrium model of bortowing and lending by continuum of stochastic endowment economies, each Subject tow nonnegatvity constraint on consumption ands condition precluding bankruptcy with prob ability one I here Is no ageregate uncertain. the model predicts that ata constant world interest rate below the rae of time preference. the equilibrium distribution of foreign assets among coun tres is described by an invariam (or steady-state) distibuio. (An invariant distribution is one that perpetuates seif once reached, sce Stokey and Lucas, 1989, p. 21.) Clanda’s revult, while special, Suggests that an approximation ike the one behind the permanent income hypothesis is justifiable ina general-equlirium setting. Other yustications could be based on an undering overlapping generations structure (see Chapter 3) or an endogenous time preference rate (see Supplement B to this chapter 20, Our shock specication assumed tht Ey ¢, =O for anys. The law of iterated conditional expecta- tions assures us that for = 5, {Ey—tey] = Eyes =O also, With aional expectations, what you expect today to expect tomorrow must be the same as what you expect today!83 2.3. A Stochastic Current Account Model Substituting in for E, {Y, — ¥} here using eq. (34) yields: (35) This simple example yields a “Keynesian” consumption function in the sense that higher current output ¥; raises consumption C; less than dollar for dollar (except in the special case p = 1, in which they rise by the same amount). Why? Under stochastic process (33), output can be written as + ¥ os, 36) so that shocks’ effects decay geometrically over time provided p < 1 (they are permanent only if p = 1).2! As a result, unexpected shifts in current output cause smaller unexpected shifts in permanent output, so that consumption-smoothing makes consumption respond less than fully to output shocks. ‘To see implications for the current account, write the consumption function (35) in terms of the unexpected shock to output, the innovation € er 5. C= 1B + ¥ + ———(h-1 - ¥) + ———- De AIC rapa eee Substituting this formula into the current account identity CA; = rBy + Y; ~ Cy gives l~p ; leo ca=(; og) tet -p+(Ee oe 6 ‘An unexpected positive shock to output (¢, > 0) causes an unexpected rise in the current account surplus when the shock is temporary (p < 1), because people smooth expected consumption intertemporally through asset accumulation. A per- ‘manent shock (p = 1) has no current account effect because consumption remains level (in expectation) if people simply adjust consumption by the full innovation to output. As we suggested in section 2.2.1, these effects are the same as in a “perfect-foresight” model that permits initial unexpected changes. The latter in- terpretation corresponds to the dynamic impulse-response profile of the present stochastic model. Equation (37) shows that the current account also has a predictable component coming from the previous period’s expected future output profile. On date 1 — 1, 21. To derive eq, (36), use the lag operator L (defined so that LX, =X, 1 forany variable X) to write 4, (33) (lagged by one period) as (I ~ pL)(¥, ~ ¥) = ¢, Its solution is ¥; ~ ¥ = (1 — pL.) '«), which is the same as eq. (36). (Supplement C to this chapter reviews the properties of lag operators.) Equation (39) is derived the same way.84 Dynamics of Small Open Economies people expected the deviation between date ¢ output and (4) ¥| > r <& 1 ali > =oi-H- FO (5) ety — PY l-p - o( dae) oe. Absent the shock ¢, which leads to a revision of expectations on date f, the preced- ing difference would equal the date current account, just as in the deterministic “permanent” level to current account equation (18) from section 2.2.1 Now suppose that, rather than following eq. (33), output follows Yes — Yr = (Ye — Yi-1) + ert (38) with 0 < p < 1, This process makes output a nonstationary random variable, @9) ‘There is only one difference between eqs. (36) and (39), but itis critical. The first equation has ¥ on its right side, the second ¥,1. This difference means that under eq. (38), an output surprise ¢; raises Y, 4; by (1 + p)e;, ¥,2 by (I+ 0 + per, and so on [whereas under eq. (33) the corresponding increases are only pé;, p7€;,.. J. Because eq. (38) makes all future output levels rise by more than ¢,, permanent output fluctuates more than current output (except in the special case p =0, in which their fluctuations are the same). Consumption smoothing now implies that ‘an unexpected increase in output causes an even greater increase in consumption. ‘As a result, a positive output innovation now implies a current account deficit, in sharp contrast to what eq. (37) for the stationary case predicts.?* Application: Deaton’s Paradox Deaton (1992) points out that in United States data, the hypothesis that output growth is positively serially correlated is difficult to reject statistically. If so, then it is a puzzle why consumption does not move more dramatically in response to output changes than it does. Put differently, given that output appears to be mean reverting in growth rates rather than levels, as in eq. (38), it is a puzzle that standard Keynesian consumption functions match the data at all! 22. Exercise 4 atthe end of the chapter asks you to verify these claims.85 23. A Stochastic Current Account Model There are several potential answers to “Deaton’s paradox.” One is that the present model is partial equilibrium and treats the interest rate as exogenous. Even small country’s output is likely to be positively correlated with world productiv- ity, in which case world interest rates can rise along with home output, damping the consumption response. Perhaps the most likely explanation is simply that itis very hard to discriminate empirically between the processes of eqs. (33) and (38) using the relatively short sample of postwar time series data. Thus output shocks may indeed dampen over time, but at such a slow rate that it is difficult to distinguish the true stationary process from a nonstationary one such as eq. (38). Unfortunately, for p near 1 even tiny differences in estimates can imply very big differences in the predicted consumption effect of output shocks. We have already seen that if eq. (33) holds and = 1, eq. (35) predicts that output and consumption will move one for one. If instead p is very close to 1, say p = 0.96, and r = 0.04, then r/(1 +r — p) =0.04/(1 + 0.04 — 0.96) = 0.5, and the consumption response is halved! Intuitively, at a real interest rate of r = 0.04, output fifteen years hence has a weight equal to more than half that of current output in permanent output ‘Thus the consumption response can be quite sensitive to the rate at which output shocks die out. . 2.3.4 Investment Suppose output is given by the production function ¥; = A, F(K,), where the pro- ductivity parameter A, is now a random variable. Since investment is J, = Ky. — K,, the constrained expected utility function that the representative domestic indi- vidual now maximizes, eq. (27), can be written as SEY > Bul +B, = Bos + ASF (Ks) = (Ks — Ks) ~ Gs] The first-order condition with respect to B,41 is still the bond Euler equation (29). Differentiating with respect to K;41 yields u!(C)) = Ey (f+ Ar F(R] Bu (Cra)} To interpret this condition, note that w(C;) is nonrandom on date 1 so that dividing it into both sides above gives ; Bul Crs) [1-4 Arne een] AGED ; Cs , (Ce B, (1+ Arak Kran] B | PCD + 000 {Arey PED86 Dynamics of Small Open Economies where Cov, {-, -} denotes the conditional covariance.” By using eq. (29) we reduce this expression to w(Co) Cov, Jars Kiss See E, {41 P’(Kis)} (40) after imposing (1 +r) = 1 This equation differs from the certainty-equivalence version of eq. (6) only be- cause of the covariance term on its right-hand side. We have assumed that all domestic capital is held by domestic residents, so the covariance is likely to be negative: when capital is unexpectedly productive (A, 1 is above its conditional mean), domestic consumption will be unusually high and its marginal utility un- expectedly low [u'(C,+1) below its conditional mean). As a result, the expected marginal product of capital on the left-hand side of eq. (40) must be higher than 7, so that the capital stock is lower than in the corresponding certainty-equivalence model. Intuitively, the riskiness of capital discourages investment. We will say more about investment under uncertainty in Chapter 5. For now we will simply ignore the covariance in eq. (40), assuming that investment is deter- mined according to the certainty-equivalence principle. Implicitly, we are treating the covariance term as a constant. Thus our discussion of investment in the rest of this section captures only part (but probably the main part) of how productivity shocks affect the current account. Empirically, changes in the covariance in eq. (40) are likely to be small compared to changes in the expected productivity of capital or in the real interest rate. Suppose that the stochastic process governing productivity shocks is Ani A=ptAr~ A) ters, 1) where 0
0, positive productivity shocks not only raise the expected path of future out- put directly, but they also induce investment (by raising the anticipated return to domestic capital), thereby raising expected future output even further. An unanticipated productivity increase on date f (€ > 0) affects the date ¢ cur- rent account via two channels, assuming eq. (32) holds. First, it raises investment, tending to worsen the current account as domestic residents borrow abroad to fi- nance additional capital accumulation. Second, the productivity increase affects saving. The magnitude of p influences whether date t saving rises, and, if so, by 23. ‘The covariance between X and ¥, Cov{X. ¥], 1s defined as E( ~ EXWY ~ EY)} =E (XY) — E{X} EY}. (The number Cov|X. X] = Var|X} 1s called the variance of X. Conditional variances and ccovanances are defined in the same way. but with conditional in place of unconditional expectations ‘operators.) In deriving the covariance in the immediately preceding equation, we made use of the fact that for any constant ay, Covlan + X.Y} = Cov (X.Y,87 2.3. A Stochastic Current Account Model more or less than investment, With reasonable generality, the more persistent pro- ductivity shocks are, the lower is CA, = S; — h. If p = 1, the current account must fall. Why? The capital stock takes a period to adjust to its new, higher level, so expected future output rises by more than current output on date ¢. At the same time, current investment rises but expected future investment doesn’t change. Saving therefore falls, while investment rises.”* On the other hand, if p is sufficiently far below 1, future output rises by less than current output, even taking account of any increases in future capital. Since, in addition, the present discounted value of current and expected future investment rises on date r, saving rises; see eq. (32). Saving may rise by even more than in- vestment. In the extreme case = 0, there is no investment response at all because a surprise date 1 productivity increase does not imply that productivity is expected to be any higher on date t + 1. The p = 0 case thus is just like the case of exoge- ous output. The country runs a higher current account surplus on date to spread over time the benefits of its temporarily higher output. For four different degrees of persistence (p = 0, 0.25, 0.75, and 1), Figure 2.3 shows the current account's dy- namic response to an unexpected 1 percent rise in productivity on date t = 0. (The ‘examples assume that r = 0.05 and that ¥ = AK4,)°5 Application: The Relative Impact of Productivity Shocks on Investment and the Current Account Empirically, productivity shocks for most countries appear to be very highly cor- related over time and indeed, it is not easy to reject the hypothesis that p = 1 in specification (41). As we have just shown, our model predicts that in this case pos- itive productivity shocks cause investment to rise and the current account surplus to fall, Moreover, because saving also falls, the current account effect is larger in ab- solute value than the investment effect. How does this prediction fare empirically? Glick and Rogoff (1995) test this hypothesis using annual time series data on productivity shocks, investment, and the current account for the “Group of Seven” 24. Why does initial saving fall, or, equivalently. why does consumption initially rise more than output ‘when p= 1? Assume a pre-shock steady state with A = A. Ifthe economy did no additional investing in response to the permanent productivity rise, it would be able to raise its consumption permanently by exactly the initial change in output. Saving would not change in this hypothetical case. Since prof- itable investment raises the economy's intertemporal consumption possibilities, however, an even higher constant consumption path actually is feasible, So saving must fall. For a small shock this further con- ‘sumption increase is second order. by the envelope theorem. 25, Notice that if p =0 or 1 the current account returns to its prior level immediately after date ¢ absent further unexpected productivity shocks, For intermediate p values, the current account moves into greater surplus on date r + | as a result ofc, > 0. (See Figure 2.3.) Output on date 1 + | exceeds its permanent level by more, and investment (which is lower than if the shock hadn't occurred) is below its permanent level by more: see eg, (42) below. The dynamics ofthe current account are quite different ‘when capital installation is costly, as in section 2.5.2. See, for example, Baxter and Crucini (199).88 Dynamics of Small Open Economies ‘Change in current account {percent of initial GOP) Figure 23 Dynamic current-aecount response to a1 percent productivity increase (G-7) countries (the United States, Japan, Germany, France, Italy, the United King- dom, and Canada). Their analysis allows for partial adjustment in investment (see section 2.5.2), but this does not alter the model’s basic prediction about the rela- live size of the current-account and investment responses to permanent productivity shocks. Glick and Rogoff derive and estimate equations of the form Bh = a9 +a AAS + aAAY + ash, ACA; = by + bLAAL + BAAN +b 3h, where A is a shock to global productivity and A‘ is the country-specific (id- iosyncratic) component of productivity shocks; the lagged / terms arise from costs of adjustment in investment. The distinction between global and country-specific productivity shocks is essential for any sensible empirical implementation of the model. Our theoretical analysis has implicitly treated all productivity shocks as affecting only the small country in question, but in reality there is likely to be a common component to such shocks across countries. Why is the local-global distinction so important? Ifa shock hits all countries in the world symmetrically, the current account effect will be much smaller (under some conditions zero) than if it hits just the one small country. If all countries try to dissave at once, the main effect will be for global interest rates to rise, There are a number of approaches for trying to decompose shocks into local and global components. In the results reported here, global productivity shocks are simply a80 2.3. A Stochastic Current Account Model Table 2.2 Pooled Tune-Senes Regressions for the G-7 Countries, 1961-90 Dependent Variable a a a al 010 (0.04) Aca 017 0.04 (003) (0.03) Standard errors in parentheses. Regressions include a time tend ‘Source: Glick and Rogofi (1995). GNP-weighted average of total productivity shocks for each of the seven countries, and country-specific shocks are formed taking the difference between the total productivity shock hitting each country and the global shock. Assuming A‘ (but not necessarily A™) follows a random walk (a hypothesis the data do not reject), then the model predicts that a, > 0, by <0, and [oy] > ay. The model also predicts that a2 > 0 and by = 0: global shocks raise investment in all countries leaving the world current account pattern unchanged. The econometric results, reported in Table 2.2, use labor-productivity measures to proxy total pro- ductivity A. ‘The data do not reject the hypothesis b> = 0, that is, that global productivity shocks do not affect current accounts. The same finding emerges from virtually all the individual-country regressions, and it appears to be robust to various changes in specification. As predicted by the model, a1, which measures the impact of country-specific productivity shocks on investment, is positive, and b), which mea- sures the impact of country-specific productivity shocks on the current account, is negative. However, the estimated absolute value of b; is consistently smaller than the estimate of ay. Results for the individual-country specifications are generally similar to the pooled cross-country regressions shown in Table 2.2. Why does investment respond much more sharply to productivity shocks than the current account does? Glick and Rogoff argue that the most likely explanation is the same as the one suggested earlier for the Deaton paradox. Even if the true process Af = pAS_, +«f has p only slightly less than 1, the current account effect of a country-specific productivity change can be greatly muted. For p = 0.96 (in annual data), Glick and Rogoff show that theoretically, a can be more than eight times as large as |bj|. Thus the fact that current accounts appear less sensitive than investment to country-specific productivity shocks is not necessarily evidence against integrated G-7 markets for borrowing and lending, .