Macroeconomía III

Aug. – Dec. 2018

Topic 1

Intertemporal Trade & the Current

Account Balance
 Class Outline

1.1 Introduction and Aims

1.2 A Small Two-Period Endowment Economy Model
1.3 Defining the Current Account
1.4 Explaining Intertemporal Trade Patterns
1.5 The Role of Government Consumption
1.6 The Role of Investment
1.7 Puzzle 1: The Feldstein and Horioka Saving-Investment Puzzle
 1.1 Introduction & Aims

• Open economies fundamentally differ from closed economies as they are

engaged in international trade
• Open economies can borrow resources from foreigners or lend resources
abroad
• These resource exchanges between countries are not static but fluctuate over
time
• Resource exchanges across time are called intertemporal trade & are
measured by the current account of the balance of payments:
• Foreign borrower → country runs a current account deficit
• Lender abroad → country runs a current account surplus
• The aim of this class is to outline the fundamental economic principles that
govern intertemporal trade patterns:

1. When are counties foreign borrowers? When and why do countries run
current account deficits? Should current account deficits be avoided?
2. When are countries overseas lenders? When and why do countries run
current account surpluses?
3. How do government policies affect the dynamics of the current account?
4. How does investment affect the dynamics of the current account?

• We will answer these questions by developing a small, two-period,

endowment economy model which we will then modify to specifically
allow for production
 Reading
• Obstfeld and Rogoff (1996), Chapter 1, Sections 1.1.1 – 1.1.6, Sections
1.2.1 – 1.2.3 and p161 – p164.
• Obstfeld and Rogoff (2001), “The Six Major Puzzles in International
Macroeconomics. Is There a Common Cause?” NBER Macroeconomics
Annual 2000, p349 – p359.
• Feldstein and Horioka (1980), “Domestic Savings and International
Capital Flows”, Economic Journal, 90, pp314 – 329.
• Coakley, Kulasi, and Smith (1998), “The Feldstein-Horioka Puzzle and
Capital Mobility: A Review,” International Journal of Finance and
Economics, 3, pp169 – 188.
• Apergis and Tsoumas (2009), “A Survey of the Feldstein-Horioka
Puzzle: What has Been Done and Where We Stand,” Research in
Economics, 63, pp64 – 76.
 1.2 The Small Two-Period Endowment Economy Model

Assumptions:

1. The universe lasts for two periods denoted 1 (“today”) and 2 (“tomorrow”)
2. There is a single, perishable (i.e. non-storable) good available for consumption
(the impact of fluctuations in intratemporal prices are ignored)
3. There is no production (function) i.e. it is an endowment economy model
4. Perfect foresight (i.e. no uncertainty). Therefore each agent knows her present
(𝑦1 ) and future (𝑦2 ) endowments of the good
5. No money i.e. it is a real model
6. Initially assume that there is no government and no investment
7. Each agent can consume, borrow or lend abroad their endowment in period 1
8. Small open economy that takes the world interest rate as given i.e. the
country is too small to affect the world interest rate

• A limitation of examining a small open economy is that the path of world

interest rate is exogenously given
• However, the small country assumption is realistic for most countries in the
world (including Mexico). There are only a few economies large enough
that their unilateral actions have an impact on world interest rates (e.g.
USA)
• In this model the world interest rate is the only relative price in the model
(i.e. between consumption in the two periods, 𝑐1 and 𝑐2 )
The Model:

• Individual i maximizes the present discounted value of her lifetime utility

𝑈1𝑖 , which depends on period consumption levels 𝑐 𝑖 :

(1) 𝑈1𝑖 = 𝑢 𝑐1𝑖 + 𝛽𝑢 𝑐2𝑖 , 0<𝛽<1

• Notice that we are assuming that consumer preferences are intertemporally

additive (i.e. consumption levels for the two periods enter additively)
• The parameter β is the subjective discount factor, which measures the
individual´s impatience to consume
• If β → 1, the individual is very patient: she values future consumption nearly as
much as current consumption. i.e. she does not “discount” the utility of
consumption in the future a lot as she is indifferent between consuming “today”
and “tomorrow”
• If β → 0, the individual is very impatient: she “discounts” the utility of future
consumption a lot as she “prefers” to consume exclusively “today”
• The subjective discount factor 𝛽 is itself defined in terms of the subjective
discount rate 𝛿:
1
𝛽≡
1+𝛿
• As usual the period utility function 𝑢 𝑐 𝑖 is assumed to be strictly increasing in
consumption, concave and twice differentiable, with derivatives: 𝑢′ 𝑐 𝑖 > 0 and
𝑢′′ 𝑐 𝑖 < 0
• A positive first derivative (known as the marginal utility of consumption)
implies that the consumer would prefer to “eat” more of the good than “less”
• However, each next unit of the good that is “eaten” would be of lower (marginal)
value to the consumer (as she gets more satiated), which is expressed
mathematically by imposing a negative second derivative
• Hence these assumptions imply that the marginal utility of consumption is
positive but diminishing
• Individual´s intertemporal budget constraint is given by:
𝑐2𝑖 𝑦2𝑖
(2) 𝑐1𝑖 + = 𝑦1𝑖 +
1+𝑟 1+𝑟

• where r denotes the real interest rate for borrowing and lending from the world
capital market in period 1 and (1 / 1 + r ) is the market discount factor (i.e. if the
real interest rate goes up the market discount factor goes down)
• Thus the present value of consumption = present value of output (endowment)
• Use (2) to eliminate 𝑐2𝑖 from (1), then the individual´s maximization problem
reduces to:
𝑖 𝑖 𝑖 𝑖
max
𝑖
𝑢 𝑐1 + 𝛽𝑢 𝑦2 + 1 + 𝑟 𝑦 1 − (1 + 𝑟)𝑐1
𝑐1
• The FOC for this problem yields the intertemporal Euler equation
𝜕𝑈1𝑖 ′ 𝑐 𝑖 + 𝛽𝑢 ′ 𝑐 𝑖 (1 + 𝑟) ∙ (−1) = 0
= 𝑢 1 2
𝜕𝑐1𝑖
(3) ⇒ 𝑢′ 𝑐1𝑖 = 𝛽(1 + 𝑟)𝑢′ 𝑐2𝑖

• i.e. for the individual to have maximized utility, she cannot gain from feasible
shifts of consumption between periods 1 and 2
• The Euler equation (3) can be arranged to yield:
𝛽𝑢′ 𝑐2𝑖 1
=
𝑢′ 𝑐1𝑖 1+𝑟

• where the LHS is the marginal rate of substitution of present for future
consumption and the RHS is the price of future consumption in terms of
present consumption
• The individual´s optimal consumption plan is found by combining the Euler
equation (3) with the intertemporal budget constraint (2)
• Consider the following special (but important) case where 𝛽 = (1 / 1 + r ) i.e.
the subjective discount rate = market discount rate (𝛿 = 𝑟)
• In this case the Euler equation becomes 𝑢′ 𝑐1𝑖 = 𝑢′ 𝑐2𝑖 which implies 𝑐1𝑖 =
𝑐2𝑖 = 𝑐ҧ𝑖 and thus from the intertemporal budget constraint (2)
1+𝑟 𝑦1𝑖 +𝑦2𝑖
(4) 𝑐ҧ𝑖 =
2+𝑟
Equilibrium:
• In order to define equilibrium we need two additional assumptions
1. all individuals are identical (i.e. we have a representative agent model)
2. the population size of the economy is constant and equal to 1,
• Thus all per capita quantities are equal to aggregate quantities i.e. 𝑐 𝑖 = 𝐶 and
𝑦𝑖 = 𝑌
• Hence the Euler equation governs the motion of aggregate consumption
(5) 𝑢′ 𝐶1 = 𝛽(1 + 𝑟)𝑢′ 𝐶2

• and if 𝛽 = (1 / 1 + r ) then (4) describes aggregate equilibrium consumption in

both periods 𝐶1 = 𝐶2 = 𝐶ҧ
1+𝑟 𝑌1 +𝑌2
(6) Cത =
2+𝑟
• While consumption is flat (i.e. the same over the two periods) at the level 𝐶,ҧ
output need not be. E.g., suppose that 𝑌1 < 𝑌2 . The country can borrow the
amount 𝐶ҧ − 𝑌1 from foreigners to aid consumption purposes in period 1
• In period 2, the country repays (1 + 𝑟)(𝐶ҧ − 𝑌1 ) and consumes
𝐶2 = 𝑌2 − (1 + 𝑟)(𝐶ҧ − 𝑌1 ) in period 2, which by inspection satisfies the
intertemporal budget constraint (2)
 1.3 Defining the Current Account
• Before we proceed we first need to define the current account in this two-period
model
• Before we do this let us consider how national income accounting differs in an open
economy from a closed economy

Closed economy:
• GDP (𝑌) and National Income (𝑁𝐼) are the same (𝑌 = 𝑁𝐼)
• where 𝑌 = 𝐶 + 𝐼 + 𝐺
• Define national savings 𝑆 = 𝑌 − 𝐶 − 𝐺, then it follows that 𝑆 = 𝐼

Open economy:
• The Balance of Payments is defined as the sum of the current account (CA) and
changes in capital account (∆𝑁𝐹𝐴): 𝐵𝑜𝑃 = 𝐶𝐴 + ∆𝑁𝐹𝐴 = 0
• i.e. a country with a positive current-account surplus (𝐶𝐴 > 0) must be buying
foreign assets (i.e. lending overseas) ∆𝑁𝐹𝐴 < 0 whereas a country with a current
account deficit (𝐶𝐴 < 0) must be selling foreign assets (i.e. borrowing from
overseas) ∆𝑁𝐹𝐴 > 0
• Thus the current account can de defined as 𝐶𝐴 = −∆𝑁𝐹𝐴

• In the open economy National Income (𝑁𝐼) (also called GNP) differs from
GDP (𝑌): 𝑁𝐼 = 𝑌 + 𝑅 where 𝑅 denotes net foreign income receipts
• Now: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀 = 𝐶 + 𝐼 + 𝐺 + 𝑇𝐵
• where the trade balance (TB) is defined as exports minus imports: 𝑇𝐵 =
𝑋−𝑀
• Thus the current account can also be defined as 𝐶𝐴 = 𝑇𝐵 + 𝑅
• It follows that:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑇𝐵
⇒ 𝑁𝐼 = 𝐶 + 𝐼 + 𝐺 + 𝑇𝐵 + 𝑅 = 𝐶 + 𝐼 + 𝐺 + 𝐶𝐴
⇒ 𝐶𝐴 = 𝑁𝐼 − (𝐶 + 𝐼 + 𝐺)

• Therefore the current account can be expressed as:

𝐶𝐴 = −∆𝑁𝐹𝐴 = 𝑌 + 𝑅 − 𝐶 + 𝐼 + 𝐺
⇒ 𝐶𝐴 = −∆𝑁𝐹𝐴 = 𝑆 − 𝐼

• where national saving is given by 𝑆 = 𝑁𝐼 − 𝐶 − 𝐺

• Now we can define the current account in this two-period model
• Since, the current account of a country over a specified time period is
simply the change in the value of its net claims on the rest of the world –
i.e. the change in its net foreign assets

𝐶𝐴𝑡 = 𝐵𝑡+1 − 𝐵𝑡
• where 𝐶𝐴𝑡 > 0 is a current account surplus and 𝐶𝐴𝑡 < 0 is a deficit
• In the absence of government consumption and capital and investment it
follows that
𝐶𝐴 = −∆𝑁𝐹𝐴 = 𝑌 + 𝑅 − 𝐶 + 𝐼 + 𝐺
⇒ 𝐶𝐴𝑡 = 𝐵𝑡+1 − 𝐵𝑡 = 𝑌𝑡 + 𝑟𝑡 𝐵𝑡 − 𝐶𝑡

• i.e. where 𝑌𝑡 + 𝑟𝑡 𝐵𝑡 is National Income (or GNP)

• Notice that in any period 𝑡 consumers can use current output 𝑌𝑡 and the
return from existing foreign asset holdings (1 + 𝑟)𝐵𝑡 in order to consume
𝐶𝑡 and invest in new assets 𝐵𝑡+1 . (Note that 1 + 𝑟 𝐵𝑡 < 0 is repayment of
foreign debt and 𝐵𝑡+1 < 0 is borrowing from abroad.)
• i.e. 𝐵𝑡+1 + 𝐶𝑡 = 𝑌𝑡 + (1 + 𝑟𝑡 )𝐵𝑡
• In our model, it follows that the current account in period 1 is:

𝐶𝐴1 = 𝐵2 − 𝐵1 = 𝑌1 + 𝑟𝐵1 − 𝐶1 = 𝑌1 − 𝐶1 = 𝐵2

• since 𝐵1 = 0. i.e. At the start of the universe, the initial wealth of the economy
is zero. In period 2, the current account is:

𝐶𝐴2 = 𝐵3 − 𝐵2 = 𝑌2 + 𝑟𝐵2 − 𝐶2 = 𝑌2 − 𝐶2 + 𝑟 𝑌1 − 𝐶1

• From the intertemporal budget constraint (2) : 𝑌2 − 𝐶2 = − 1 + 𝑟 𝑌1 − 𝐶1

• Thus the current account in period 2 can be expressed as:

𝐶𝐴2 = − 𝑌1 − 𝐶1 = −𝐵2 = −𝐶𝐴1

• Thus the current account equations tell us that any deficit (or surplus) in period
1 must be matched with an equal surplus (or deficit) in period 2
• As a result the cumulative current account balance can be expressed as:

𝐶𝐴1 + 𝐶𝐴2 = 𝐵2 − 𝐵1 + 𝐵3 − 𝐵2 = 0

• since 𝐵1 = 0 as previously discussed, and 𝐵3 = 0. i.e. At the end of the

universe the economy holds no uncollected claims on foreigners (and
foreigners do not wish to die holding uncollected claims on the home
country either!)
• To get some intuition behind our results, it will be useful to compare the
open economy equilibrium with the autarky (closed economy) case
• In autarky countries cannot lend and borrow from abroad and so 𝑌 = 𝐶 in
both periods
• Define the autarky interest rate 𝑟 𝐴 as the interest rate that achieves the
same consumption profile as autarky. In other words the Euler equation (5)
must still hold
𝛽𝑢′ 𝐶2 𝛽𝑢′ 𝑌2 1
(7) = =
𝑢′ 𝐶1 𝑢′ 𝑌1 1+𝑟 𝐴
 1.4 Explaining Intertemporal Trade Patterns

1. A balanced current account is not always desirable

• According to this model, current account deficits or surpluses are not

necessarily a bad thing (as some economic commentators would have you
believe!)
• Consider the following figure. This combines the representative agent´s
indifference curves with the intertemporal budget constraint (2), graphed as
𝐶2 = 𝑌2 − (1 + 𝑟)(𝐶1 − 𝑌1 )
• The economy’s optimal consumption choice is at point C (where the budget
constraint is tangent to the highest indifference curve)
• The country does better running an unbalanced current account in both
periods (a deficit in period 1 and a surplus in period 2) than it would if
forced to balance its current account in both periods i.e. by setting 𝐶1 =
𝑌1 and 𝐶2 = 𝑌2 (the autarky point A)
• Intertemporal trade helps smooth consumption over time. The utility gain
between point A and C illustrates that countries gain from trade
• Unlike closed economies, an open economy can use external borrowing
and lending to eliminate an important kind of risk: undesirable fluctuations
in aggregate consumption
• The above figure assumes that the autarky interest rate of the domestic
economy is above the world interest rate 𝑟 𝐴 > 𝑟
• Consequently the country will find it relatively cheaper to borrow from
abroad to “import” current consumption (run a current account deficit) in
the first period, in exchange for repaying the debt in the next period by
“exporting” future consumption
• Thus to summarize:
1. Without trade:
• country faces the interest rate 𝑟 𝐴
• the intertemporal budget constraint is 𝐶2 = 𝑌2 − (1 + 𝑟 𝐴 )(𝐶1 − 𝑌1 )
• produces and consumes at point A where the slope of the intertemporal
𝜕𝐶
budget constraint 2 = −(1 + 𝑟 𝐴 ) is equal to the slope of highest
𝜕𝐶1
indifference curve
• Thus the representative agent consumes at point 𝑌1 in period 1 and point 𝑌2
in period 2
 2. With trade: suppose 𝑟 𝐴 > 𝑟.
• country faces the world interest rate 𝑟
• the intertemporal budget constraint is 𝐶2 = 𝑌2 − (1 + 𝑟)(𝐶1 − 𝑌1 )
• produces at point A but consumes at point C where the slope of the intertemporal
𝜕𝐶
budget constraint 2 = −(1 + 𝑟) is equal to the slope of highest indifference curve
𝜕𝐶1
• In this case the slope of the budget line is smaller than the slope of the budget line
under autarky
• Then the agent in period 1 has higher consumption 𝐶1 but still produces (or is
endowed with) 𝑌1 , thus accumulating a current account deficit −𝐶𝐴1 = 𝑌1 − 𝐶1
• This borrowed consumption is repaid in period 2, where the economy produces at 𝑌2
but consumes at 𝐶2 , thus generating a current account surplus 𝐶𝐴2 = 𝑌2 − 𝐶2
• Consequently, international borrowing and lending allow the economy to achieve a
higher level of welfare (i.e. point C is on a higher indifference curve to point A)
which is only achievable through intertemporal trade
• If 𝑟 𝐴 < 𝑟 then there are still welfare gains from international trade. In this case the
domestic economy has a comparative advantage in current consumption, and will
thus run a CA surplus in the first period (consumption is lower than the endowment)
and a CA deficit in the second period (consumption is higher than the endowment)
• The greater the difference between 𝑟 and 𝑟𝐴 the larger the gain from intertemporal
trade. The only case of no gain would occur when 𝑟 𝐴 = 𝑟
2. Temporary changes in output affect the current account:
→ Temporary increase in output (or a decrease in future expected output) generate
current account surpluses
→ Temporary decrease in output (or an increase in future expected output)
generate current account deficits

1
• To see this formally, consider the case when 𝛽 = . Then equation (7)
1+𝑟
becomes:
𝛽𝑢′ 𝑌2 1 𝑢′ 𝑌2 1+𝑟
′
= 𝐴
⇒ ′ = 𝐴
(8)
𝑢 𝑌1 1+𝑟 𝑢 𝑌1 1+𝑟

• which by inspection suggests that changes in the output level is the only factor
responsible for differences between the world and autarky interest rates. That is,
𝑟 𝐴 ≠ 𝑟 ⟺ 𝑌1 ≠ 𝑌2
• An economy that expects a constant steam of endowments i.e. 𝑌1 = 𝑌2 = 𝑌ത will
1
plan on a balanced current account. This follows because with 𝛽 = then
1+𝑟
from (6), the consumption path is flat 𝐶1 = 𝐶2 = 𝐶ҧ
• What happens to the economy if it is hit by a positive temporary shock? i.e.
𝑌1 > 𝑌ത but 𝑌2 = 𝑌ത
• From (8), 𝑟 𝐴 < 𝑟 and the representative agent lends some of her temporarily
high output to foreigners. Thus the country runs a current account surplus in
period 1 𝑌1 − 𝐶1 > 0
• A negative temporary shock i.e. 𝑌1 < 𝑌ത but 𝑌2 = 𝑌,
ത would give rise to a current
account deficit in period 1 and the borrowing to smooth consumption would be
repaid in period 2
• Therefore when output temporarily fluctuates the economy borrows or lends to
smooth consumption

3. Permanent changes in output have no affect on the current account

• With permanent shocks e.g. 𝑌1 = 𝑌2 < 𝑌, ത then from (8) there is no change in 𝑟 𝐴
and thus there is no effect on the current account
• With a temporary shock to output, consumption smoothing is possible. If the
shock is permanent then consumption must also change permanently
• Consumers can smooth out temporary changes to output, but they must adjust to
permanent changes. For example, if your income is reduced by 20% this month,
you can borrow the shortfall so that there is a minimal adjustment in your
consumption. But if your income is permanently lower 20% every month, then
your consumption must fall
• In a closed economy, consumption equals output in every period, so output
fluctuations immediately generate consumption fluctuations. In an open
economy consumption smoothing can be achieved by running a current account
deficit when output is temporarily low or a surplus when output is temporarily
high
• Thus the country avoids consumption volatility to temporary output shocks
• Even though these results where derived in a very simplified economy they are
valid in multi-period models (next week) and in large economy models
• In practical terms, the distinction between temporary and permanent shocks
is not always observable
• However, there are cases in which shocks can clearly be classified as
temporary
• One such case is the occurrence of natural disasters
• Natural disasters with significant economic impact temporarily reduce
output. If agents prefer a smooth consumption pattern, we should observe a
deterioration of the CA, which acts as a buffer stock isolating households
from the negative shock by allowing them to borrow from the rest of the
world
• An interesting example of this mechanism can be seen in the two
earthquakes that affected the northeastern part of Ecuador in 1987
• Ecuador suspended petroleum exports for a period, and output dropped by
almost 6% in 1987 (down from 3% growth in 1986)
• The following figure plots the rate of growth of real GDP, the CA to GDP
ratio, and the consumption to GDP ratio (right scale)
• The data confirms the predictions of our intertemporal model of the current
account
• While consumption remains relatively constant, the CA deficit increases to
−11.3% in the face of a temporary GDP drop
• Notice also that another major output drop occurs in 1999
• However, in this case the CA deficit surprisingly shrinks, and consumption
drops substantially
• The reason is that the 1999 crisis was associated with a collapse of the Ecuador
banking sector and a partial default on external debt
• Under these circumstances, it is not difficult to imagine that international
capital markets would not be willing to lend to such an unstable economy
• That is, without access to international borrowing, country’s cannot smooth
consumption in the face of output shocks!
• This highlights an important problem with our simple model, particularly for
developing countries
• We have assumed throughout that the country can borrow or lend as much as it
wants at the prevailing world interest rate
• However sometimes there is a sudden stop in the flow of external finance
• Suppose a borrower country is not able to borrow anew or roll over its
existing debt
• Without access to international capital, the country has no option but to
reduce its current account deficit (since there is no way to finance its trade
imbalance)
• This sudden adjustment could cause a collapse in output
• Next week, after we develop a multi-period version of our intertemporal
current account model, we can use it to predict when countries are close to
bankruptcy and thus in danger of being cut off from world capital markets
 1.5 The Role of Government Consumption

• We want to add government consumption to our model to see how government

policy affects intertemporal trade
• Suppose that government consumption per capita, G, is introduced additively into
the utility function, implying a period utility of the form 𝑢 𝐶 + 𝑣 𝐺
• Lifetime utility now becomes

𝑈1 = 𝑢 𝐶1 + 𝑣 𝐺1 + 𝛽𝑢 𝐶2 + 𝛽𝑣 𝐺2

• where we have assumed there is a representative national consumer (to dispense

with the i notation)
• We assume that to finance its consumption the government collects taxes from the
private sector, 𝑇1 and 𝑇2 and balances its budget in each period 𝐺1 = 𝑇1 and 𝐺2 = 𝑇2
• The intertemporal budget constraint is now given by:
𝐶2 𝑌2 − 𝑇2
𝐶1 + = 𝑌1 − 𝑇1 +
1+𝑟 1+𝑟

𝐶2 𝑌2 − 𝐺2
⇒ 𝐶1 + = 𝑌1 − 𝐺1 +
1+𝑟 1+𝑟
• Government spending also enters the current account identity, which is now
expressed as:
𝐶𝐴𝑡 = 𝐵𝑡+1 − 𝐵𝑡 = 𝑌𝑡 + 𝑟𝑡 𝐵𝑡 − 𝐶𝑡 − 𝐺𝑡
• Here both government and private consumption are subtracted from national
income to compute the current account
• Introducing government consumption in this manner is equivalent to
expressing the private sector´s endowment as output net of government
consumption 𝑌 − 𝐺
• Since government consumption enters additively into the utility function, the
FOC (the Euler equation) remains unchanged (3)
• How does government spending affect international trade patterns?

4. Temporary changes in government spending affect the current account:

→ Temporary increase in government spending generates a current account
deficit
→ Temporary decrease in government spending generates a current account
surplus
• To see this we can use (again) as a benchmark the case when 𝛽 = (1 / 1 + r )
and output is constant 𝑌1 = 𝑌2 = 𝑌ത
• In the absence of government, equilibrium consumption is:

1+𝑟 𝑌1 +𝑌2 ത 𝑌ത
1+𝑟 𝑌+
𝐶ҧ = = = 𝑌ത
2+𝑟 2+𝑟

• and the current account is balanced

𝐶𝐴1 = 𝑌ത + 𝑟1 𝐵1 − 𝐶ҧ = 𝑌ത − 𝐶ҧ = 0

• Now suppose 𝐺1 > 0 and 𝐺2 = 0. Equilibrium private consumption:

1 + 𝑟 (𝑌1 −𝐺1 ) + 𝑌2 − 𝐺2 1 + 𝑟 (𝑌ത − 𝐺1 ) + 𝑌ത

𝐶ҧ = =
2+𝑟 2+𝑟
(1 + 𝑟)𝐺1
ҧ
⇒𝐶 =𝑌− ത
2+𝑟
 (1 + 𝑟)𝐺1
𝐶ҧ = 𝑌ത −
2+𝑟
• Private consumption is lower in both periods. Government consumption in period
1 reduces 𝐶ҧ but by an amount less than 𝐺1
• This follows since government consumption is temporary (it drops to zero in
period 2)
• The current account in period 1 is in deficit:
𝐺1
ത ҧ
𝐶𝐴1 = 𝑌 + 𝑟1 𝐵1 − 𝐶 − 𝐺1 = − <0
2+𝑟
• With a temporary increase in government consumption in period 1, the consumer
will want to borrow against its relatively high period 2 (after tax) income to shift
part of the burden of the temporary taxes to the future i.e. ‘spread the pain’
• Therefore, the country runs a current account deficit in period 1 and a surplus in
period 2
• Permanent changes in government consumption have no effect
• For example, suppose now 𝐺2 > 0 is permanently raised. For simplicity assume
that 𝐺1 = 𝐺2 = 𝐺ҧ
• Then it is straightforward to show that equilibrium consumption is 𝐶ҧ = 𝑌ത − 𝐺ഥ in
both periods and the current account is always balanced
 1.6 The Role of Investment
• We want to add investment to our model to see how this affects intertemporal
trade (we will once again ignore government consumption from the analysis)
• Now output is not anymore an exogenous endowment. We have a production
economy!
• Output is now produced using capital, accumulated through investment, which
in turn is a function of savings.
• The production function for output in each period is given by
𝑌=𝐹 𝐾 (9)

• We make the standard assumptions of diminishing returns to capital so that

output is a positive but decreasing function of the capital stock
• Formally, this implies that the first derivative of F with respect to capital is
positive, and the second derivative is negative: 𝐹 ′ 𝐾 > 0 and 𝐹 ′′ 𝐾 < 0 and
𝐹 0 = 0 (i.e. output cannot be produced without capital)
• For simplicity we assume that a unit of capital is created from a unit of the
consumption good and this process is reversible (i.e. a unit of capital, after
being used to produce output, can be “eaten”)
• Capital accumulates through investment (𝐼) and, for simplicity, we abstract from
capital depreciation:
𝐾𝑡+1 = 𝐾𝑡 + 𝐼𝑡 (10)

• Nothing restricts investment to be nonnegative, so (10) allows people to eat part

of their capital
• With investment, the current account is the difference between national savings
𝑆𝑡 = 𝑌𝑡 + 𝑟𝐵𝑡 − 𝐶𝑡 and investment 𝐼𝑡 :

𝐶𝐴𝑡 = 𝐵𝑡+1 − 𝐵𝑡 = 𝑆𝑡 − 𝐼𝑡 = 𝑌𝑡 + 𝑟𝐵𝑡 − 𝐶𝑡 − 𝐼𝑡 (11)

• National saving in excess of domestic investment flows into net foreign asset
accumulation
• To derive the lifetime budget constraint when there is investment analogous to
equation (2) in our original endowment model, we write the current account (11)
for periods 1 and 2
𝐶𝐴1 = 𝐵2 − 𝐵1 = 𝑌1 + 𝑟𝐵1 − 𝐶1 − 𝐼1
⇒ 𝐵2 = 𝑌1 − 𝐶1 − 𝐼1 (12)
• since 𝐵1 = 0
• For period 2:
𝐶𝐴2 = 𝐵3 − 𝐵2 = 𝑌2 + 𝑟𝐵2 − 𝐶2 − 𝐼2
𝐶2 + 𝐼2 − 𝑌2
⇒ 𝐵2 =
1+𝑟
• since 𝐵3 = 0. Substituting 𝐵2 from (12) yields the lifetime budget
constraint
𝐶2 + 𝐼2 𝑌2
𝐶1 + 𝐼1 + = 𝑌1 + (13)
1+𝑟 1+𝑟

• A logical further simplification is that people would not, rationally, leave

any capital beyond the terminal period 2. Thus, similar to our previous
assumption that 𝐵3 = 0 we now also impose 𝐾3 = 0 which implies:

𝐼2 = 𝐾3 − 𝐾2 = −𝐾2 (14)

• The utility function for the representative agent is the same as (1):
i.e. 𝑈1 = 𝑢 𝐶1 + 𝛽𝑢 𝐶2
• Using (13) with (14) to eliminate 𝐶2 from 𝑈1 yields the following
unconstrained optimization problem
 max 𝑢 𝐶1 + 𝛽𝑢 1 + 𝑟 𝐹 𝐾1 − 𝐶1 − 𝐼1 + 𝐹 𝐾1 + 𝐼1 + 𝐼1 + 𝐾1
𝑐1 ,𝐼1

• where we have used the identity 𝐾2 = 𝐾1 + 𝐼1 and 𝑌1 = 𝐹 𝐾1 and 𝑌2 =

𝐹 𝐾2 = 𝐹(𝐾1 + 𝐼1 ). Note that 𝐾1 is inherited and is not subject to choice
• The first optimality condition is the standard Euler equation
𝜕𝑈1
= 𝑢′ 𝑐1 + 𝛽𝑢′ 𝑐2 (1 + 𝑟) ∙ (−1) = 0
𝜕𝑐1
⇒ 𝑢′ 𝑐1 = 𝛽(1 + 𝑟)𝑢′ 𝑐2

• The second optimality condition is given by

𝜕𝑈1
= 𝛽𝑢′ 𝑐2 1 + 𝑟 ∙ −1 + 𝐹 ′ 𝐾2 + 1 = 0
𝜕𝐼1
⇒ 𝐹 ′ 𝐾2 = 𝑟 (15)

• In a closed economy with competitive factor markets, equation (15) has the
usual interpretation that the marginal product of capital 𝐹 ′ (𝐾2 ) is in
equilibrium the same as the real interest rate 𝑟
• In an open economy context equation (15) says that period 1 investment should
continue to the point at which its marginal return 𝐹 ′ (𝐾2 ) equalises the return on
lending to the rest of the world 𝑟
• That is, the marginal return of an extra unit of capital equals the opportunity
cost, interpreted as the best alternative use of the extra unit of investment
• A critical feature of (15) is its implication that the desired capital stock is
independent of domestic consumption preferences
• In other words, unlike in the closed economy case, saving and investment
decisions are separated!
• To analyze graphically the determination of the current account, we need a
production possibility frontier (PPF) that shows the technological possibilities
available in autarky for transforming period 1 consumption into period 2
consumption
• The PPF is defined by the following equation:
𝐶2 = 𝐹 𝐾1 + 𝐹 𝐾1 − 𝐶1 + 𝐾1 + 𝐹 𝐾1 − 𝐶1
𝜕𝐶2 𝜕2 𝐶2
• which is a strictly concave curve =− 1+ 𝐹′ 𝐾2 < 0 and =
𝜕𝐶1 𝜕2 𝐶1
𝐹 ′′ 𝐾2 < 0
• given the diminishing returns to capital assumption
• How do we derive and interpret the PPF?
• First note that in a closed-economy the single good can be either consumed or
invested. Thus 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡
• Consider the horizontal intercept of the PPF. Here 𝐶2 = 0 (and thus it follows that
𝐾2 = 𝑌2 = 𝐼2 = 0). What is the optimal 𝐶1 ?
• The inherited capital stock 𝐾1 is first used for production purposes 𝑌1 = 𝐹(𝐾1 )
• and then it is completely “eaten” 𝐾1 = −𝐼1 (since 𝐼1 = 𝐾2 − 𝐾1 = −𝐾1 with
𝐾2 = 0) so that there is negative investment (“disinvestment”)
• In other words, there is no point in investing in the next period since you do not
plan to consume!
• Hence: 𝐶1 = 𝑌1 − 𝐼1 = 𝐹 𝐾1 + 𝐾1

• Now consider the vertical intercept of the PPF. Here 𝐶1 = 0 and thus 𝑌1 = 𝐶1 +
𝐼1 = 𝐼1 . What is the optimal 𝐶2 ?
• The inherited capital stock 𝐾1 is first used for production purposes 𝑌1 = 𝐹(𝐾1 )
• and then it is completely invested 𝐼1 = 𝑌1 = 𝐹(𝐾1 )
• In period 2, all capital is first used to produce output 𝑌2 = 𝐹(𝐾2 ) and then it is
completely “eaten” 𝐾2 = −𝐼2 (since 𝐼2 = 𝐾3 − 𝐾2 = −𝐾2 with 𝐾3 = 0)
• Hence: 𝐶2 = 𝑌2 − 𝐼2 = 𝐹 𝐾2 + 𝐾2 = 𝐹 𝐾1 + 𝐹 𝐾1 + 𝐾1 + 𝐹 𝐾1
• Since from the capital accumulation equation it follows that 𝐾2 = 𝐾1 + 𝐼1 =
𝐾1 + 𝐹(𝐾1 )

• In the following diagram, point A is the autarky equilibrium

• Here the slope of the PPF equals the slope −(1 + 𝑟 𝐴 ) of the intertemporal budget
constraint (not depicted) which equals the slope of the highest indifference curve
• In the closed economy output production and consumption both occur at point A:
1. Producer Maximization: investment decisions are efficient from the optimality
condition (15), 𝐹 ′ 𝐾2 = 𝑟 𝐴
2. Consumer Maximization: Euler equation holds
3. Output-market clearing: 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡 in both periods. For example it is
straightforward to write the PPF equation as:

𝐶2 = 𝐹 𝐾1 + 𝐹 𝐾1 − 𝐶1 + 𝐾1 + 𝐹 𝐾1 − 𝐶1
⇒ 𝐶2 = 𝐹 𝐾1 + 𝑌1 − 𝐶1 + 𝐾1 + 𝑌1 − 𝐶1 = 𝐹 𝐾1 + 𝐼1 + 𝐾1 + 𝐼1
⇒ 𝐶2 = 𝐹 𝐾2 + 𝐾2 = 𝑌2 − 𝐼2
• What happens in the open-economy? Lets assume that 𝑟 < 𝑟 𝐴
• Now the economy can benefit by borrowing abroad to increase investment in
period 1 and thus produce more output in period 2
• Production moves from 𝑨 ⟶ 𝑩 placing the economy on the highest feasible
budget line at world prices
• At the same time, intertemporal trade enables the economy to smooth
consumption by consuming more in period 1. Consumption moves from 𝑨 ⟶ 𝑪
• This illustrates the advantages of intertemporal trade which are greater in the
production economy compared to our earlier endowment economy
• The horizontal distance 𝑨𝑩 is the extra investment generated by opening the
economy to the world capital markets since 𝑟 < 𝑟 𝐴
• The horizontal distance 𝑨𝑪 is the extra first-period consumption that trade
simultaneously allows
• Since total first-period resources 𝑌1 + 𝐾1 have not changed the distance 𝑩𝑪 is
the current account deficit in period 1
• Had the world interest rate been 𝑟 > 𝑟 𝐴 then the country would have run a
current-account surplus in period 1 but still enjoyed gains from intertemporal
trade, as in our previous endowment model
• Therefore, an open economy not only gains from consumption smoothing but it
also gains on the investment side
• In this model a remarkable result is revealed

5. In an open economy consumption and investment decisions are separable

• Firms and households save or borrow in the world capital markets

• Open economies can delink investment decisions from savings decisions and
thus from consumption decisions!
• The economy address the investment problem by setting the marginal rate of
capital equal to the world interest rate
• The economy can then address the separate problem of how to smooth the path
of consumption
• A closed-economy has to be self-sufficient. Any resources invested are
resources not consumed. All else equal, more investment implies more savings
and less consumption which creates a nasty trade-off
• In an open-economy, one can take advantage of any investment opportunities
without having to engage in a trade-off against the important objective of
consumption smoothing
• This result of the separation of investment from consumption decisions in
the economy is however sensitive to changes in the models assumptions:
1. It is a feature that only arises in small open economies since the saving
decisions of the country do not change the interest rate at which
investment projects can be financed in the world capital market
2. In this model we assumed the economy produces and consumes a single
tradable good. When the economy also produces non-traded goods then
consumption shifts can affect investment
3. Here we assumed that capital markets are free of imperfections. However
in the presence of default risk or capital controls, access to international
borrowing will be restricted and then national saving will influence
domestic investment
 1.7 Puzzle 1: The Feldstein and Horioka Saving-Investment Puzzle

• In a closed-economy, national saving equals domestic investment and the

current account is always zero
• Thus any observed increase in national saving will automatically be
accompanied by an equal rise in domestic investment
• One of the main implications of our intertemporal open economy model is the
separation between savings and investment i.e. savings and investment can
diverge, as countries with opportunities to gain from international trade run
unbalanced current accounts
• Accordingly, if capital mobility is high between countries, savings and
investment should display a low degree of correlation, and hence an increase in
savings would not force an automatic increase in investment in the open
economy
• The first attempt at documenting such relationship is in Feldstein and Horioka
(1980)
• Feldstein and Horioka run a cross-section regression of the average investment
rates (I/Y) on average savings rates (S/Y) for 16 OECD countries for the 1960-
1974 period
• Their regression revealed striking results (standard errors in parentheses):
0.04 0.89
𝐼/𝑌 = (0.02) + (0.07) 𝑆/𝑌, 𝑅2 = 0.91

• The association between savings and investment for this group of developed
countries is surprisingly high
• The coefficient is very significantly different from zero and close to one in value
• This came to be known as the “Feldstein-Horioka puzzle” since even with
international capital mobility, countries current accounts tend to be surprisingly
small relative to total saving and investment
• With high levels of capital mobility the coefficient 0.89 should be much smaller,
as each country’s savings seek out the most productive worldwide investment
opportunities
• While, over time this Feldstein-Horioka coefficient has fallen in both
developing and developed countries, there still exists a very significant and
positive association between domestic saving and domestic investment
 Correlation between Saving and Investment 1970 – 2010
Developing Countries Developed Countries
Argentina 0.92 Austria 0.80
Bolivia 0.08 Belgium 0.83
Colombia 0.85 Canada 0.87
Honduras 0.10 Denmark 0.78
Mexico 0.59 Finland 0.85
Paraguay 0.26 France 0.93
Peru 0.65 Germany 0.80
Turkey 0.68 Italy 0.66
Uruguay 0.88 Japan 0.91
Venezuela 0.56 Netherlands 0.81
New Zealand 0.78
Sweden 0.87
Switzerland 0.67
USA 0.85
Average 0.56 Average 0.81
• There are numerous potential theoretical explanations of the Feldstein-
Horioka puzzle
• For example, governments sometimes adjust monetary or fiscal policies to
avoid large and protracted current-account imbalances
• However as discussed by Obstfeld and Rogoff (2001), while there are a
number of explanations (over 15!), none are very convincing empirically [if
you are interested read the surveys by Coakley, Kulasi, and Smith (1998)
and/or Apergis and Tsoumas (2009)]
• Instead Obstfeld and Rogoff (2001) put forward transport costs as a potential
explanation for the Feldstein-Horioka puzzle
• The idea here is that with the presence of transport costs, a small open
economy will behave in a fairly autarkic manner, suppressing the desire to
run large CA deficits/surpluses
• Consequently, savings and investment should display a high degree of
correlation as supported by the data
• To see this, lets consider a one-good version of Obstfeld and Rogoff (2001)
two-good model
• The one-good model is less general but makes the logic of their point more
transparent (I think!)
• The model is very similar to our original two-period endowment model except
for the inclusion of transport costs
• The utility function of the representative agent is again given by:
𝑈1 = 𝑢 𝑐1 + 𝛽𝑢 𝑐2 ,

• And her lifetime budget constraint is again given by:

𝑖
𝑐2𝑖 𝑖
𝑦2𝑖
𝑐1 + = 𝑦1 +
1+𝑟 1+𝑟

• Assume that the single good has the global price 𝑃∗ which is constant over the
two periods and which the home country takes as given
• Assume that the transportation costs are such that a fraction 𝜏 of the good
“melts” in transit
• Thus the home price of the good (i.e. net of transport costs) is:
𝑃∗
= 𝑖𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 (𝐶𝑡 > 𝑌𝑡 )
1−𝜏
𝑃 ∗
𝑃𝑡
∈ 1 − 𝜏 𝑃∗ , 𝑖𝑛 𝑎𝑢𝑡𝑎𝑟𝑘𝑦 (𝐶𝑡 = 𝑌𝑡 )
1−𝜏
= 1 − 𝜏 𝑃∗ 𝑖𝑓 𝑡ℎ𝑒 𝑐𝑜𝑢𝑛𝑡𝑟𝑦 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 (𝐶𝑡 < 𝑌𝑡 )
• As before, if the home country runs a trade deficit (surplus) in the first period it
must run a trade surplus (deficit) in the second period
• Hence, if the country engages in trade, it pays the trade cost twice, once when it
imports goods from abroad and once when it exports
• This creates a relatively large incentive not to trade!
• Trade costs generate a wedge between the world interest rate 𝑟 ∗ and the
effective domestic real interest rate 𝑟, given by:

∗
𝑃1
1 + 𝑟 = (1 + 𝑟 )
𝑃2

• Suppose the country runs a current account deficit in period 1 and thus a current
𝑃∗
account surplus in period 2. Thus 𝑃1 = and 𝑃2 = (1 − 𝜏)𝑃∗ and the
1−𝜏
domestic real interest rate is greater than the world interest rate:

∗
𝑃1 1 + 𝑟∗ ∗
1+𝑟 = 1+𝑟 = > 1 + 𝑟
𝑃2 (1 − 𝜏)2
• Now suppose the country runs a current account surplus in period 1 and thus a
𝑃∗
current account deficit in period 2. Thus 𝑃1 = (1 − 𝜏)𝑃∗and 𝑃2 = and the
1−𝜏
domestic real interest rate is lower than the world interest rate:

𝑃1
1+𝑟 = 1+ 𝑟∗ = 1−𝜏 2 1 + 𝑟∗ < 1 + 𝑟∗
𝑃2

• To see why autarky might be optimal consider the individual maximization

problem:
𝑃1 𝑃1
max 𝑢 𝑐1 + 𝛽𝑢 𝑦2 + 1 + 𝑟 ∗ 𝑦1 − 1 + 𝑟 ∗ 𝑐1
𝑐1 𝑃2 𝑃2

• The FOC for this problem yields the intertemporal Euler equation
𝑃1 ′
𝑢′ 𝑐1 = 𝛽(1 + 𝑟 ∗ ) 𝑢 𝑐2
𝑃2
 𝑢′ 𝑐1 𝑃
∗
• If 𝛽 = (1 / 1 + 𝑟 ) then = 𝑃1 . In autarky 𝑌 = 𝐶 in both periods and 𝑃𝑡 ∈
𝑢′ 𝑐2 2
∗ 𝑃∗
1−𝜏 𝑃 , then no trade will take place:
1−𝜏

𝑢′ 𝑌1 𝑃1
= ∈ (1 − 𝜏)2 , (1 − 𝜏)−2
𝑢′ 𝑌2 𝑃2

• For example with log utility 𝑢′ 𝑌 = 1/𝑌, the above condition becomes:
𝑌2
(1 − 𝜏)2 < < (1 − 𝜏)−2
𝑌1

• Therefore, transport costs can drive a wedge between the effective domestic real
interest rate and the world real interest rate
• This can induce the home country not to trade for an interval of endowments
• Explaining the Feldstein-Horioka puzzle by the same logic requires an explicit
consideration of investment opportunities at home and abroad
• If, the return on the marginal domestic investment remains between (1 − 𝜏)2 and
(1 − 𝜏)−2 times the return on investments abroad, then the agent invests all his
savings at home, and domestic saving and investment behave in the same way as
under autarky
• Domestic saving will be perfectly correlated with domestic investment, as in the
Feldstein-Horioka puzzle!