Question

Copy the Model of Current Account Determination with a Government Sector

Use the two-period, small open endowment economy model and discuss the importance of each variable in model to the determination of current account (or in sustaining current account)t in an economy. (Note that you have government, households etc. in the model)

Answer 1

Copy the Model of Current Account Determination with a Government Sector:-

A Simplified device that will allow us to measure and predict, in this case, the CA, Useful: the equations of the model map to national accounts, We ll see the former later, let us start by understanding how the model maps to the national accounts.

Consumer Budget Constraint and National Accounts:-Let us consider a model where there are consumption, savings, and investment and there is no government.

Denote time as t and GNDI as Yt.

By our derivations in the previous class CAt = Yt Ct It . Savings are simply St = Yt Ct .

Then as before CAt = St,

It must hold for that model

In that model, there are no valuation changes. So that we also have CAt = Bt Bt1

where Bt is the NIIP

Finally,

Model Assumptions

Let us now consider the formal model for 2 periods. A small open economy

Consumers:

Representative consumer

Period 1: allocates income to consumption or bonds (saving)

Consumption: C1, C2

Bonds B0 (initial savings), B1, B2. Given interest r0, r1

Endowment Economy: Q1, Q2 available to the consumer

Equilibrium: World interest rate equals r.

Impose no saving in last period B2 = 0 (optimal in equilibrium)

Normalize the price of the good to 1, in each period

Modeling the Government: Twin Deficits: Fiscal & Current Account Deficits

The conjecture that an important determinant of CA deficit is fiscal deficit(affect government savings and thus total savings)

The mechanism: Remember that CA = S I where savings are private and government savings, S = Sp + SG

If expansion in government spending leads to fewer government savings and Sp remains constant, CA will show a larger deficit.

Correlation: fiscal deficits various times coincide with CA deÖcits

E.g. Reagan tax cuts caused large deÖcits, same time CA turned negative

E.g.2 Obama stimulus plan, also at a time where deÖcit is very large

Yet in other times the correlation is weak or the opposite from what expected

E.g. Clinton administration or WWII

So much for the accounting identity.

We need to model the government!