Chapter 16: International Trade in Goods and Assets
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Questions and Answers

What are the learning objectives of Chapter 16?

Construct the first two-period small open economy (SOE) model, Show how the first two-period SOE model explains the determinants of the current account balance, Modify the first two-period SOE model to incorporate credit market imperfections and the possibility of national default on debt, Construct the second two-period SOE model with production and investment and show how this model is used to understand the links between international trade and domestic macroeconomic activity.

Why has international trade become increasingly important during the twentieth and twenty-first centuries?

  • Decrease in transportation costs
  • Relaxation of trade restrictions
  • Development of world financial markets
  • All of the above (correct)

    • Why may there not be obvious evidence of consumption smoothing in data even though economic theory suggests nations should smooth consumption?

    Synchronization in business cycles across countries

    In small open-economy models, domestic actions significantly impact world prices.

    <p>False</p> Signup and view all the answers

    What is the limited commitment constraint when it comes to a nation defaulting on its debt?

    <p>C + G = (Y - B) / (1 + r)</p> Signup and view all the answers

    In a small open economy, economic agents treat prices in other countries and interest rates on world credit markets as _____.

    <p>given</p> Signup and view all the answers

    Defaulting on debt can affect a nation's ability to borrow in the future.

    <p>True</p> Signup and view all the answers

    In Equation (16-7), B' represents the nation's indebtedness at the beginning of the ______ period.

    <p>future</p> Signup and view all the answers

    What impact did Greece entering the Euro area in 2001 have on its government bond yields compared to Germany?

    <p>converged</p> Signup and view all the answers

    Prior to entering the Euro area in 2001, participants in world credit markets charged the Greek government higher interest rates than the German government because of a perceived risk of default or unexpected inflation. Which statement reflects this situation?

    <p>Greek government debt had lower yields than German government debt.</p> Signup and view all the answers

    Inflating away the value of a country's debt is considered implicit default.

    <p>True</p> Signup and view all the answers

    The ratio of government debt to GDP for Greece increased rapidly from 107% in 2007 to ___% in 2011.

    <p>170</p> Signup and view all the answers

    What tends to be associated with high interest rates when it comes to countries defaulting?

    <p>debt</p> Signup and view all the answers

    In the model with production and investment, what is the relationship between the current account surplus and events in the domestic economy?

    <p>Inversely proportional</p> Signup and view all the answers

    In the small open-economy model, an increase in the world real interest rate leads to a decrease in the current account surplus.

    <p>False</p> Signup and view all the answers

    According to the model, government spending increases result in __________ in the current account surplus.

    <p>decreases</p> Signup and view all the answers

    What is the quantity of government savings in the given economy?

    <p>T - G</p> Signup and view all the answers

    According to Equation (16-4), what must equal the present value of national income in the SOE model?

    <p>C + G + (C' + G')/(1+r) = Y + Y'</p> Signup and view all the answers

    How does the current account surplus change with an increase in current income?

    <p>Increases</p> Signup and view all the answers

    Changes in taxes have an effect on the current account surplus.

    <p>False</p> Signup and view all the answers

    If CA < 0, an increase in the real interest rate ______________ the current account surplus.

    <p>increases</p> Signup and view all the answers

    What does an increase in current total factor productivity lead to in a closed economy?

    <p>Increases labor demand, real wage, employment, output, and decreases the real interest rate.</p> Signup and view all the answers

    How does an anticipated increase in future total factor productivity affect a closed economy?

    <p>Increases current demand for investment and consumption goods, aggregate output, and the real interest rate.</p> Signup and view all the answers

    What happens to the current account surplus when current total factor productivity increases?

    <p>The current account surplus increases.</p> Signup and view all the answers

    What effect does an increase in anticipated future total factor productivity have on the current account surplus in a closed economy?

    <p>Decreases</p> Signup and view all the answers

    Why could it be a good thing for a country to run a current account deficit?

    <p>To stimulate economic growth through increased borrowing and investment.</p> Signup and view all the answers

    What can constrain borrowing in world markets by an individual country?

    <p>Limited creditworthiness and high levels of existing debt.</p> Signup and view all the answers

    What makes a country more likely to default on its international debt?

    <p>Weak economic fundamentals and inability to meet payment obligations.</p> Signup and view all the answers

    What are the effects of an increase in the world real interest rate on output, absorption, and the current account surplus?

    <p>Higher interest rates can reduce output, decrease absorption, and potentially improve the current account surplus.</p> Signup and view all the answers

    What are the effects of a temporary increase in government expenditure on output, absorption, and the current account surplus?

    <p>A temporary increase in government spending can boost output and absorption but may worsen the current account surplus.</p> Signup and view all the answers

    What are the effects of an increase in current and future total factor productivity on output, absorption, and the current account surplus?

    <p>An increase in total factor productivity can enhance economic output, raise absorption levels, and may affect the current account surplus positively.</p> Signup and view all the answers

    How do we explain the post-1990 behavior of investment expenditures and the current account surplus in the United States?

    <p>Post-1990, the U.S. saw a decrease in savings rate and an increase in foreign borrowing, leading to higher investment rates and current account deficits.</p> Signup and view all the answers

    Study Notes

    International Trade in Goods and Assets

    • Chapter 16 focuses on extending closed-economy models to address international macroeconomics issues
    • International trade has become increasingly important due to:
      • Reduced transportation costs
      • Relaxed government-imposed trade barriers (GATT, WTO, regional agreements like NAFTA and EU)
      • Developed world financial markets and freer flow of assets across countries

    The Importance of International Trade

    • Understanding international trade is crucial for domestic macroeconomic activity
    • This chapter studies the impact of trade on domestic output, employment, consumption, investment, and current account surplus

    Small Open-Economy Models

    • Assumes actions of consumers and firms have no collective effect on world prices
    • Models are simple to work with and can be modified from closed-economy models
    • Conclusions derived from small open-economy models are similar to those from large open-economy models
    • The small open-economy assumption becomes more realistic for countries like the US over time

    A Two-Period Small Open-Economy Model

    • Modifies the two-period model from Chapter 9 to incorporate international borrowing and lending
    • Representative consumer lives for two periods, with exogenous income and lump-sum taxes
    • Consumer can borrow and lend at the world real interest rate, r
    • Lifetime budget constraint: C + C'/(1+r) = Y - T + Y'/(1+r)
    • Private saving, government saving, and the current account surplus are determined by consumer choices

    Determinants of the Current Account Surplus

    • Increases in current income increase the current account surplus, as consumers smooth consumption over their lifetime
    • Increases in future income decrease the current account surplus, as consumers adjust their consumption and savings
    • Changes in taxes have no effect on the current account surplus, assuming Ricardian equivalence
    • Credit market imperfections can affect the current account surplus
    • An increase in the real interest rate increases the current account surplus if the country is a net borrower### Credit Market Imperfections and Default
    • National indebtedness is important, especially in times of financial stress, such as the global financial crisis of 2008-2009.
    • National indebtedness consists of both private and sovereign debt, which can be difficult to disentangle.
    • The global financial crisis highlighted sovereign debt problems in European countries, such as Greece, Spain, Italy, and Portugal.

    The Model of National Indebtedness

    • The model adapts the first two-period SOE model to incorporate credit market imperfections and the possibility of national default on debt.
    • The nation's budget constraint is C + G = Y + (B' - B) / (1 + r), where B is the nation's debt to the rest of the world.
    • The future period national budget constraint is C' + G' = -B' + Y'.
    • Limited commitment means that the nation can default on its debt, facing a penalty v, which captures the cost of being denied access to credit markets in the future.

    Default and National Consumption Smoothing

    • The model shows that countries may not smooth consumption over time as theory predicts.
    • In the US, current account deficits are not always associated with low income, and surpluses with high income, as would be expected.
    • Synchronization of business cycles across countries may explain this phenomenon.

    Greece and Sovereign Default

    • Greece's entry into the Euro area in 2001 led to a convergence of Greek government bond yields with German government bond yields.
    • However, Greece's high level of government debt led to a perceived likelihood of default, increasing interest rates faced by the Greek government.
    • The Greek government eventually required assistance from the International Monetary Fund, the European Union, and the European Central Bank.### Sovereign Default and Debt
    • In 2008-2009, the yield on Greek government debt began to rise, and by 2011 and 2012, the situation had become dire.
    • In June 2012, international creditors were willing to lend to Germany for 10 years at a much lower interest rate than Greece.
    • Greece's debt-to-GDP ratio increased from 107% in 2007 to a peak of 170% in 2011.
    • Germany, Canada, the United States, and Japan had higher debt-to-GDP ratios, but were not perceived to be likely to default.

    Sovereign Default Model

    • The decision to default is determined by which option implies a higher level of current consumption.
    • Default is more likely if the current value of the nation's indebtedness is higher.
    • Default is less likely if the national cost of defaulting is larger.
    • A higher world real interest rate reduces the right-hand side of the equation and makes default more likely.

    International Trade in Goods and Assets

    • The current account surplus is the quantity of aggregate output that is exported (NX).
    • The domestic demand for goods, C + I + G, is sometimes referred to as absorption.
    • The quantity NX is the current account surplus, or net exports.

    The Second Two-Period SOE Model with Production and Investment

    • The model includes production and investment behavior.
    • Goods can be freely traded with foreign countries.
    • The world real interest rate determines the domestic demand for consumption goods and investment goods.
    • If total domestic demand exceeds the domestic supply of goods at the world real interest rate, then goods are imported and net exports are negative.

    The Effects of an Increase in the World Real Interest Rate

    • The current account surplus increases, causing the output demand curve to shift to the right.
    • Domestic investment decreases, but domestic consumption may rise or fall.

    Government Expenditure and the Current Account

    • An increase in government spending shifts the output supply curve and output demand curve to the right.
    • The current account surplus decreases.
    • The real interest rate does not increase in the open economy, as the interest rate is determined on world markets.
    • Crowding out occurs in different ways in an open economy, and it is crowding out of net exports, since the current account surplus has gone down.

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    Learn about international trade in goods and assets, and understand the small open economy (SOE) model. Discover how the SOE model explains the determination of trade balance and exchange rates.

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