Chapter 15 International Trade in Goods and Assets Copyright © 2014 Pearson Education, Inc.

1-2 © 2014 Pearson Education, Inc. Chapter 15 Topics A two-period open economy model – the current account. Credit market imperfections and default. Production, investment, and the current account. Effects of changes in the world real interest rate, government spending, and productivity.

1-3 © 2014 Pearson Education, Inc. A Two-Period Small Open Economy Model Two periods – current period and future period. Representative consumer with exogenous current-period and future-period incomes. The SOE is a price-taker on world credit markets – the real interest rate is exogenous. The current account surplus here is equal to savings in the SOE, as there is no investment.

1-4 © 2014 Pearson Education, Inc. Lifetime Budget Constraint The representative consumer’s lifetime budget constraint:

1-5 © 2014 Pearson Education, Inc. Government The government’s intertemporal budget constraint:

1-6 © 2014 Pearson Education, Inc. Figure 15.1 The Two-Period Small Open-Economy Model

1-7 © 2014 Pearson Education, Inc. Credit Market Imperfections and Default Problems with national indebtedness were important during the financial crisis and after, particularly in southern Europe. Use ideas on credit market frictions from Chapter 10 to address sovereign debt issues – model of limited commitment.

Figure 15.2 Deviations from Trend in the Current Account Surplus and GDP 1-8 © 2014 Pearson Education, Inc.

1-9 © 2014 Pearson Education, Inc. Budget Constraints for the Nation B = nation’s (private sector + government) debt to the world at beginning of current period. B’ = nation’s debt at beginning of future period Current period budget constraint: Future period budget constraint:

1-10 © 2014 Pearson Education, Inc. Constraints for the Nation National present-value budget constraint: Limited commitment constraint: Or:

1-11 © 2014 Pearson Education, Inc. Figure 15.3 Default is Chosen in the Current Period

1-12 © 2014 Pearson Education, Inc. Figure 15.4 Default is not Chosen

1-13 © 2014 Pearson Education, Inc. Default When does a nation default on its debts? Default occurs when national debt is large, when the perceived future penalties from defaulting are small, and when the real interest rate is high.

1-14 © 2014 Pearson Education, Inc. A Small Open Economy with Production and Investment Works the same as the real intertemporal model, except the real interest rate is determined on world credit markets, and given to the SOE. Current account surplus always adjusts so that the aggregate supply and aggregate demand curves intersect at the world real interest rate.

1-15 © 2014 Pearson Education, Inc. Figure 15.5 A Small Open-Economy Model with Production and Investment

1-16 © 2014 Pearson Education, Inc. Figure 15.6 An Increase in the World Real Interest Rate

1-17 © 2014 Pearson Education, Inc. Figure 15.7 A Temporary Increase in Government Spending

1-18 © 2014 Pearson Education, Inc. Figure 15.8 An Increase in Current Total Factor Productivity

1-19 © 2014 Pearson Education, Inc. Figure 15.9 An Increase in Future Total Factor Productivity

Figure Investment as a Percentage of GDP 1-20 © 2014 Pearson Education, Inc.

Figure Current Account Surplus as a Percentage of GDP 1-21 © 2014 Pearson Education, Inc.