International Business Chapter 17 Case Not Sustainable Because Assumes One Can Borrow Larger And Larger Amount

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17 Balance of Payments I: The Gains from Financial Globalization

Notes to Instructor

Chapter Summary

This chapter connects the balance of payments to long-run economic growth and

highlights the benefits of international finance for consumption smoothing, investment,

and risk sharing. The key lessons from this chapter are as follows:

■ An open economy is able to smooth consumption through borrowing or lending,

affecting its current account and external wealth position.

■ Even when countries are unable to borrow or lend internationally, they can share

risk through diversifying their portfolio of capital across countries.

Comments

This chapter makes heavy use of present value and intertemporal trade–offs. Students

may find this material unfamiliar. Instructors will find it useful to review the basic

concept of present value and to highlight the difference between thinking in a dynamic

model and thinking in a static one. Also, students may be intimidated by the math used in

this chapter because it is somewhat technical.

The section is broadly organized as follows:

1. The Limits on How Much a Country Can Borrow: The Long-Run Budget

Constraint

a. How the Long-Run Budget Constraint Is Determined

vi. Extending the Theory to the Long Run

b. A Long-Run Example: The Perpetual Loan

c. Implications of the LRBC for Gross National Expenditure and Gross

Domestic Product

d. Summary

e. Application: The Favorable Situation of the United States

iv. Too Good to Be True?

2. Gains from Consumption Smoothing

a. The Basic Model

b. Consumption Smoothing: A Numerical Example and Generalization

i. Closed Versus Open Economy: No Shocks

c. Summary: Save for a Rainy Day

d. Side Bar: Wars and the Current Account

3. Gains from Efficient Investment

a. The Basic Model

b. Efficient Investment: A Numerical Example and Generalization

i. Generalizing

c. Summary: Make Hay While the Sun Shines

d. Application: Delinking Saving from Investment

Countries?

iv. An Augmented Model: Countries Have Different Productivity Levels

f. Application: A Versus k

i. More Bad News?

g. Side Bar: What Does the World Bank Do?

4. Gains from Diversification of Risk

a. Diversification: A Numerical Example and Generalization

i. Home Portfolios

b. Application: The Home Bias Puzzle

c. Summary: Don’t Put All Your Eggs in One Basket

6. Appendix: Common Versus Idiosyncratic Shocks

An alternative organization for class lecture is given in the following. This combines

1. The Limits on How Much a Country Can Borrow: The Long-Run Budget

Constraint

2. Gains from Consumption Smoothing

3. Gains from Efficient Investment

4. Linking the LRBC to Economic Growth and Investment

a. Can Poor Countries Gain from Financial Globalization?

5. Linking the Model to Risk Diversification

6. Appendix: Common Versus Idiosyncratic Shocks

Lecture Notes

Now that we have covered the accounting of international transactions, we are prepared

to analyze their meanings in two different contexts: the long run (this chapter) and the

short run (the following chapter).

When a country seeks to increase investment, this involves a difficult trade–off.

Although investment is key to economic growth and prosperity, investing in capital

resources today requires giving up consumption. In the same way that an individual takes

S = I + CA

This chapter shows how open economies can benefit from financial globalization

through borrowing or saving with other countries to (1) smooth consumption and (2)

1 The Limits on How Much a Country Can Borrow: The Long–Run Budget

Constraint

We know from the previous chapter that borrowing or lending internationally has

implications for external wealth. This chapter extends the analysis of external wealth to

study how this variable evolves over time, using the intertemporal approach.

Understanding how countries lend and borrow is easy once household lending and

loan amount is reduced with each payment, over the life of the loan, the fraction of each

payment that is principal rises, while the fraction that is interest falls. The final payment

is mostly principal with just a bit of interest. Consider two cases:

■ Case 1 A debt that is serviced. The household makes interest payments on the

Case 2 is not sustainable because it assumes one can borrow a larger and larger amount

each year by rolling over the amount owed each period. This is also known as a pyramid

How the Long–Run Budget Constraint Is Determined

We begin with the assumptions used in the model:

■ Prices are perfectly flexible. This means the model can be defined in real terms,

■ The country is a small open economy. This means the country’s behavior

(borrowing or lending) does not affect prices or interest rates in world markets

and that there are no capital controls.

■ All debts carry a real interest rate r*, the world real interest rate.

Calculating the Change in Wealth Each Period Consider the change in external wealth

in a given period, N:

This expression says that external wealth will change from two sources: trade deficits or

surpluses and net interest income earned on external wealth from the previous period.

Calculating Future Wealth Levels Adding WN−1 to both sides yields the following

expression for external wealth in period N:

This expression can be applied to calculate future external wealth based on the country’s

trade balance, TBN, and initial external wealth, WN−1.

The Budget Constraint in a Two–Period Example Suppose there are two periods in the

economy. The current period denoted is 0 (= N) and the previous period is denoted −1 (=

The next period is denoted 1 (= N + 1):

Substituting in the expression for current external wealth, W0, we get

Note that the country’s external wealth in period 1 depends on the amount of external

wealth accumulated through net interest income earned and the trade balance each period

prior. Now, if we assume that all debts must be repaid, then the country should have no

external wealth in the last period (period 1 in this case), W1 = 0. Based on this

assumption, we have the following:

Present Value Form The previous expression can be rewritten by dividing both sides by

(1 + r*):

A Two–Period Example The previous expression shows that the present value of future

trade balances must be equal to the negative of the present value of wealth from the last

period, −(1 + r*)W−1. In other words:

then this country is a net lender and therefore can afford to run future trade

deficits because it initially has positive external wealth.

then this country is a net debtor and therefore must run trade surpluses to pay off

its debts.

Extending the Theory to the Long Run It’s straightforward to extend the two-period

case to N periods. The LRBC becomes

If students feel comfortable with summation notation, it can be expressed as

This expression says that an initial credit or debit must be balanced by offsetting trade

surpluses or deficits in the future. Again, it is worth highlighting that the stream or sum of

A Long–Run Example: The Perpetual Loan

This example considers a perpetual loan in which a country pays a fixed amount, X, each

period, beginning in period 1 and lasting forever. This is a useful case to study because it

is equivalent to Case 1 from the beginning of the chapter (e.g., the principal is rolled

over, while the borrower pays interest that accrues each year). The present value of this

stream of payments is expressed as

Multiply both sides by (1 + r*):

Subtracting the first expression from the second one, we see PV(X) = X/r*:

For example, consider a fixed payment of $400 at an interest rate of 10%:

Implications of the LRBC for Gross National Expenditure and Gross Domestic

Product

Now that we are familiar with how external wealth changes over time and how this

relates to trade balances, we can use the LRBC to understand the link between GNE = C

The LRBC says that in the long run, in present value terms, a country’s expenditures

(GNE) must equal its production (GDP), plus any initial wealth.

This shows how a country is able to finance the differences between its production

Summary

In a closed economy, TB = 0, so production and expenditure must be equal. In an open

economy, a country can spend more than it produces by borrowing, or it can produce

APPLICATION

The Favorable Situation of the United States

Recall two key assumptions from the LRBC: the same, constant real interest rate, r*,

“Exorbitant Privilege” Since the 1980s, the United States has been a net debtor, r*W <

0, yet net factor income from abroad has been positive during this period. How does a net

debtor earn positive interest income?

The U.S. earns interest at the world interest rate r* on its external assets but pays

“Manna from Heaven” In addition to the difference in interest rates on assets and

liabilities, the United States has consistently enjoyed capital gains on external wealth.

This amounts to roughly 2 percentage points in net capital gains (net of capital losses on

Summary The United States has earned about 3.5% per year more than the rest of the

world (earning 2% in capital gains plus 1.5% more in interest). This has been going on

since the 1980s. The total return differential was near zero for every other G7 country.

We can modify the LRBC to relax the two assumptions about interest rates and

capital gains:

Too Good to Be True? The two additional effects in the previous expression show how

diminishing over time.

Research by Daniel Gros seems to show that the United States borrowed $5.5 trillion

between 1986 and 2006. However, U.S. external wealth as reported had fallen by only

APPLICATION

The Difficult Situation of the Emerging Markets

In the previous application, we saw that applying the LRBC model to the United States

required relaxing some assumptions. If we consider emerging markets, we similarly must

relax the model’s assumptions to account for special situations in these countries. This

application considers two assumptions: (1) the interest rates paid on assets and liabilities,

risk premium (e.g., compare Italy to Israel and Jamaica).

■ As public debt rises, the bond ratings fall much more for non-advanced countries

(e.g., compare Austria and the United States to Poland and India).

2 Gains from Consumption Smoothing

This section uses the LRBC together with a simple model of an economy to illustrate

The Basic Model

This section uses the same assumptions as outlined at the beginning of the LRBC section.

In addition:

■ GDP = Q produced using a single input: labor.

■ Analysis begins in period 0, with given initial wealth equal to zero, W−1 = 0.

■ The country is small, the rest of the world (ROW) is large, and the prevailing

world interest rate is constant at r* = 5%.

Based on these assumptions:

Consumption Smoothing: A Numerical Example and Generalization

We consider two cases to see how a country can smooth consumption:

The following examples use the same numerical values as those used in the textbook. For

a complete discussion of common versus idiosyncratic shocks, see the appendix. The

following discussion examines idiosyncratic shocks.

Closed Versus Open Economy: No Shocks

■ Closed economy: Q = 100 = C

In an open economy with no shocks, there is no reason to borrow or lend. The country is

able to maintain smooth consumption every period.

Closed Versus Open Economy: Shocks Suppose there is a temporary negative shock to

output, or −21 units. Output is equal to 100 units in every period afterward.

■ Closed economy: Q0 = 79 = C0

Note that in the open economy, the present value of output is the same, yet the country is

able to smooth consumption by running a trade deficit in the period when the negative

shock reduces output.

How to solve for the numerical values. We can use the LRBC equation:

Based on our assumptions, this expression simplifies to

Or, using the formula for a perpetual loan, we get

Because the country begins with initial external wealth equal to zero, the present value of

the trade balance must be equal to 0, that is, the present value of consumption must be

equal to the present value of output:

PV(Q) = PV(C)

Steps to computing numerical values for Q, C, TB, NFIA, and W over time are as follows:

1. Identify the initial level of output (as a result of the shock). From the example, we