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3. Calculate consumption each period based on the assumption that the country
wants to maintain the same level of consumption each period. Step 2 shows us
4. Calculate the trade balance in each period. Now that we have pinned down output
5. Calculate the country’s external wealth and the implied interest payments
paid/received on this debt to calculate net factor income from abroad (NFIA) in
6. Calculate the country’s current account in each period. Recall that the current
Generalizing Using the previous method, we can draw some general conclusions
regarding how consumption changes in response to changes in output in the open
The left-hand side represents the amount paid or received in interest on the amount
borrowed or lent. Solving for the change in consumption, we get
The value of r*/1 + r* must be between 0 and 1. That implies the open economy only
Smoothing Consumption When a Shock Is Permanent If a country faces a permanent
shock to output, then it will be forced to adjust its consumption regardless of whether it is
a closed or an open economy. In this case, the trade balance cannot be used to make up
Summary: Save for a Rainy Day
The previous model shows how a country can save output when it experiences positive
S I D E B A R
Wars and the Current Account
In our example, we assumed no government spending (G). If we incorporate G into the
model, GNE = C + G, so government spending simply represents more consumption
government can pay for this added expenditure by running trade deficits.
A combination of rapid financial development in the 1700s and the end of the
APPLICATION
Consumption Volatility and Financial Openness
Based on our model, countries with greater financial openness should be in a better
position to smooth consumption. In the data, we can measure this as the ratio of the
volatility of consumption relative to the volatility of output. According to the model, this
Why? In the real world, households are not identical and global capital markets are
not open to every individual or firm. In fact, some people and businesses do not even
APPLICATION
Precautionary Saving, Reserves, and Sovereign Wealth Funds
If poorer countries are not able to rely on global financial markets, then what is their best
strategy to smooth consumption? One such approach is to rely on precautionary saving,
in which the government acquires a “rainy day” fund in case of a sudden stop (sudden
decrease in capital inflow). In this case, the country will maintain a higher balance of
these countries vie for politically sensitive equity and FDI from advanced countries.
As of 2010, the countries with the biggest sovereign wealth funds were China ($831
billion), Abu Dhabi ($654 billion), Norway ($471 billion), and Saudi Arabia ($415
billion), with other large funds (between $50 and $150 billion each) in Kuwait, Russia,
Singapore, Qatar, Libya, Australia, and Algeria.
H E A D L I N E S
Copper-Bottomed Insurance
This article uses the case study of Chile as a copper exporter to discuss how the reliance
on export commodities can lead to output volatility, and how sovereign wealth funds can
help buffer against these shocks.
Background:
■ Chile’s government benefited from profits on its state-owned copper company
and taxes collected from private-owned mines. It used these profits for an
Key Statistics:
■ As of December 2014, there was $14.3 billion in the fund. This accounted for
5.4% of Chile’s GDP that year.
Lessons:
■ Commodity exports such as oil and copper are very volatile in price, and therefore
so is the value of output available to the country for expenditure.
Discussion Questions:
■ Should Chile set aside these profits? Or should the government spend these profits
to improve living standards in Chile?
■ How does your answer depend on the type of government spending to be
implemented?
3 Gains from Efficient Investment
This section incorporates investment into the previous model, showing how financial
openness benefits the economy through not only consumption smoothing but also
increased investment opportunities.
The Basic Model
From the previous model, we can now assume that output is produced using capital,
which is accumulated through investment, so GNE = C + I. From the LRBC, we can
derive
Present value of Q = Present value of C + Present value of I
As before, we will examine two cases:
■ Closed economy: TB = 0 in all periods, so the LRBC is automatically satisfied.
Efficient Investment: A Numerical Example and Generalization
We will consider the previous case, with shocks. Instead of a negative shock to output,
here, we consider a new investment opportunity in year 0. Assume the investment
opportunity requires 16 units of output today and will increase output by 5 units in every
Steps to computing numerical values for Q, C, TB, NFIA, and W over time are as
follows:
2. Calculate the present value of output, assuming the investment project is
undertaken:
3. Calculate consumption each period, based on the assumption that the country
wants to maintain the same level of consumption each period. From Step 2, we
know PV(Q) = 2,200 = PV(C) + PV(I ). Therefore, we know that the present value
4. Calculate the trade balance in each period. Now that we have determined output,
investment, and consumption, we can calculate the initial trade balance in the year
5. Calculate the country’s external wealth and the implied interest payments paid or
received on this debt to calculate NFIA in each period. External wealth is equal to
6. Calculate the country’s current account in each period. Recall that the current
account is the sum of the trade balance, net factor income, and net unilateral
Generalizing The country’s objective is to maximize the present value of consumption.
There are investment projects that are not worthwhile because they do not increase output
The change in the present value of investment (equal to the change in capital stock, K) is
The investment project is worthwhile only if the present value of output increases (gains
from the project) more than the present value of investment (cost of the project financed
through borrowing):
The left-hand side shows the annual benefit of the project and the right-hand side is the
cost (interest payments on the debt accumulated). Rearranging the expression gives us
Summary: Make Hay While the Sun Shines
In an open economy, a country is able to separate its consumption and investment
decisions. Firms and households can borrow or save through the world capital market. To
choose an efficient level of investment, the country should undertake investment projects
APPLICATION
Delinking Saving from Investment
A massive oil reserve was discovered in the North Sea in the 1960s, but it was very costly
to extract this oil at the time. The world price of oil was low until the oil price shocks in
the 1970s. These shocks turned out to be largely permanent, leading to a permanent
increase in the price of oil that then made the extraction of North Sea oil profitable.
Figure 17-6 shows national savings, investment, and the current account for
Norway—a country that needed a large initial capital project to extract North Sea oil.
During the mid- to late 1970s, Norway’s investment increased sharply while national
Can Poor Countries Gain from Financial Globalization?
The previous model shows us that countries with MPK > r* should borrow from abroad to
Production Function Approach A production function describes how a country’s output
depends on its inputs. In per worker terms, the production function describes the
relationship between capital per worker (k = K/L) and productivity (q = Q/L). The simple
production function used here is
where 0 <
θ
< 1 and
θ
measures the elasticity of output with respect to capital. It is also
equal to the capital share of output. The variable A measures the productivity level in the
country.
To determine the efficient level of investment, we need to know the MPK:
A Benchmark Model: Countries Have Identical Productivity Levels This model
assumes that all countries have the same production function.
■ Suppose a country considers increasing its capital per work by 8 times the current
level.
Now, we consider two different countries.
■ Suppose that a poor country has half the level of output per worker enjoyed in the
The general result is that the poorer the country, the lower its capital per worker and
therefore the higher its MPK. This relationship is illustrated on Figure 17-7, panel (a).
The textbook considers the specific case of Mexico relative to the United States
The Lucas Paradox: Why Doesn’t Capital Flow from Rich to Poor Countries?
The implication from the previous model is clear: capital should flow from rich to poor
countries, and poor countries should implement government policies to attract capital
inflow.
An Augmented Model: Countries Have Different Productivity Levels The augmented
model allows for different countries to have different productivity levels—different
values for A. Let the subscript P denote a poor country and the subscript R denote a rich
country:
θ
θ
The ratio of the MPK in each country is
APPLICATION
A Versus k
Table 17-5 compares the ratio of output per worker and capital per worker in selected
countries to those in the United States. These ratios can be used to calculate the implied
difference in the productivity levels in poor countries relative to the United States. From
the table, we observe that the implied gains from the benchmark model are much larger
than those implied by the augmented model.
More Bad News? There are other assumptions in the model that we could relax to study
a richer set of explanations for why capital does not flow from rich to poor countries:
■ The model makes no allowance for risk premiums. The existence of a risk
■ Risk premiums may be large enough to cause capital to flow “uphill” from poor
to rich countries. If risk premiums are large enough, investors in poor countries
less attractive.
■ The model assumes that investment goods can be acquired at the same relative
■ The model assumes the contribution of capital to production is equal across
countries. Poor countries may have a lower capital share,
θ
, especially those
countries that rely on natural resources that require little capital input.
■ The model suggests that foreign aid may do no better than foreign investors in
There is a recent trend toward ensuring that aid is directed efficiently through oversight
by organizations like the U.S. Millennium Challenge Corporation and the World Bank.
Past experience suggests little potential success. Research examining how aid is used
shows that there is little relationship between institutions and whether aid is invested
efficiently.
S I D E B A R
What Does the World Bank Do?
the same time.) The World Bank's main division is the International Bank for
Reconstruction and Development. There are 185 member countries, with each member
contributing capital to the organization. The Bank provides financing and technical
assistance to reduce poverty and to promote sustainable economic growth. Because the
H E A D L I N E S
A Brief History of Foreign Aid
This article considers the role of foreign aid in economic growth.
Background:
■ In 1985, Live Aid concerts were performed to raise funds to fight poverty in
Africa.
Key Statistics:
■ Corrupt rulers have misused foreign aid—Mobutu Sese Soko of Zaire ($4 billion)
■ Yacyreta Dam between Paraguay and Argentina ($12 billion)
and received aid.
Lessons:
■ During the Cold War, much foreign aid was offered more for geopolitical
purposes than to promote economic growth, so historical analysis of the effects of
Discussion Questions:
■ What criteria would you establish in offering aid to poor countries?
■ How would you address the issue of corrupt rulers in impoverished countries?
■ Would you offer foreign aid to help increase output per worker, or not?
■ The Bush administration established the Millennium Challenge Account designed
to target assistance to “smart” policies. What types of policies would you suggest
for this program?
4 Gains from Diversification of Risk
In the previous section, we observed that in practice, countries may not have access to the
world capital market. Are there other ways to cope with shocks to output? Yes, through
diversification. When a country uses diversification, it is able to reduce the volatility in
income through issuing capital equity claims without borrowing or lending.
Diversification: A Numerical Example and Generalization
In this section, we assume there are two countries with no borrowing/lending. The two
Home Portfolios Assume the countries are closed. In this case, each country owns 100%
World Portfolios Table 17-6, panels (b) and (c), shows outcomes when each country
