14.

54 International Economics
Handout 4
Guido Lorenzoni
October 31, 2006

1 The Current Account

A country has GDP Yt , consumption Ct and investment It . We can write the
trade balance in a given period as
Yt − Ct − It
where all variables are in dollars. This is the amount of dollars that enters the
country to pay for goods.
The country assets are denoted by At and the liabilities by Lt .
Suppose assets and liabilities receive the same rate of return rt . Each period
rt At dollars enter the country to pay for the services of the assets that we hold
abroad, and rt Lt exit the country to pay for the services of the assets that
foreigners hold at home.
For now, we omit the public sector for simplicity. Then the net amount of
dollars entering the country is:

CAt = Yt − Ct − It + rt At − rt Lt
this is the current account surplus.
The current account surplus must go to finance either the accumulation of
assets or the decumulation of liabilities:
(At+1 − At ) − (Lt+1 − Lt ) = Yt − Ct − It + rt At − rt Lt .
This is the basic current account identity.

Now we can decompose GDP into two parts: non-tradable goods and trad
able home-produced goods:
Yt = YtN T + YtH .
We can decompose consumption and investment in three parts:non-tradable
goods, tradable home-produced goods and foreign-produced goods:
Ct = CtNT + CtH + CtF ,
It = ItN T + ItH + ItF .

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 For non-tradable goods the following accounting identity holds

YtNT = CtNT + ItN T ,

this means that all non-tradables are used at home (this must be true by defi
nition).
Then we can rewrite the trade balance as:
¡ H ¢ ¡ ¢
Yt − CtH − ItH − CtF + ItF =
EXPt − IM Pt

and see that the trade balance is equal to exports minus imports.

2 A Two Period Model

Consider two countries, Home and Foreign. The world lasts two periods. There
is one commodity, wheat. There are n identical consumers in country Home
and n in country Foreign. Consumption of wheat by Home consumers in peri
ods 1 and 2 is denoted c1 and c2 and will be determined in equilibrium. The
preferences of consumers are described by the utility function

u (c1 ) + βu (c2 ) , β ∈ [0, 1]

Consumption by Foreign consumers is denoted c∗1 and c∗2 . Their preferences are
identical to Home consumer preferences.
Each consumer at Home owns a farm that produces a given amount of wheat
in each period, y1 and y2 . For the Foreign country we have y1∗ and y2∗ . Wheat
cannot be stored. Wheat can be transported at no cost from country Home to
Foreign.

The countries can borrow and lend from each other on the international
capital market at the interest rate r.
Let b denote the savings of home consumers. Consumers in country Home
determine their optimal savings solving

max u (c1 ) + βu (c2 )

s.t. b = y1 − c1 ,
c2 = y2 + (1 + r) b.

If b < 0 the consumers are net borrowers, if b > 0 they are net lenders.
The budget constraints in periods 1 and 2 can be combined to give the
intertemporal budget constraint
1 1
c1 + c2 = y1 + y2 .
1+r 1+r
Consumer Choice

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 Consider the case where

u (c) = log c.
Then optimal consumption entails
µ ¶
1 1
c1 = y1 + y2 ,
1+β 1+r
µ ¶
β (1 + r) 1
c2 = y1 + y2 .
1+β 1+r

Consumers take their total lifetime income, in net present value,

1
y1 + y2 ,
1+r
and spend a fraction 1/ (1 + β) in the first period of their life and a fraction
β/ (1 + β) in the second period of their life.
Autarky (Closed Financial Markets)
Market clearing requires
b = 0,
which implies

c1 = y1 ,
c2 = y2 .

The savings of home country are

b (r) = y1 − c1 =
∙ ¸
1 1
= βy1 − y2 .
1+β 1+r

So if we set b = 0 we obtain the following condition:

y2
= β(1 + ra )
y1
Market Equilibrium
Put together the consumption choice of Home and Foreign consumers and
write the market clearing condition for wheat in period 1

b (r) + b∗ (r) = 0.

Which is the same as:

CA1 + CA∗1 = 0
(since they start with zero assets the current account is equal to the assets
accumulated at the end of period 1).

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 You obtain

b (r) = −b∗ (r)

µ ¶ ∙ µ ¶¸
1 1 ∗ 1 ∗ 1 ∗
y1 − y1 + y2 = − y1 − y1 + y
1+β 1+r 1+β 1+r 2

Let ytw denote the world per capita endowment of wheat, that is
1

y
tw =
(yt + yt∗ ) ,

and let
y2w
1+g =
y1w
be the world groth rate.
Then we obtain µ ¶

1 1 w
y
1w + y
= y1w ,
1+β 1 + r
2
and finally we obtain the equilibrium interest rate on the world market
1
1+r = (1 + g) .
β
The equilibrium interest rate does not depend on the income profile of individual
countries, only on the common discount factor β and on the world-wide growth
rate g.
Graphically:
Implications
Suppose µ ¶
1 β
y1 < y1 + y2 ,
1+β 1+g
or
y2
> 1 + g.
y1
Then the home country will borrow in period 1 and repay in period 2.
Proof:
µ ¶ µ ¶
c1 1 1 y2 1 1+g
= 1+ > 1+ =1
y1 1+β 1 + r y1 1+β 1+r

and we obtain
c1
>1⇒b<0
y1
• The country growing faster borrows from the country growing slower, to
finance early consumption.

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 Figure 1:

Notice that writing

y2
>1+g
y1
is the same as writing
µ ¶
1 y2
y1 < y1 + β
1+β 1+g
the right hand side is a the net present value of income at the equilibrium world
interest rate. We call it “permanent income.” So this means that:
• The country with income in period 1 lower than its permanent income bor
rows from the country with income in period 1 higher than its permanent
income.

The growth rate of consumption will be equal for the two countries and equal
to the world growth rate. You can get it straight from the first order condition
1 1

= β (1 + r)

c1 c2

and from the equilibrium interest rate. This gives us

y2∗ c∗ c2 y2
∗ < 2∗ = 1 + g =
<

y
1 c1 c1 y1

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].

 • International capital markets induce a more similar consumption path

across countries, i.e. they make the path of consumption less responsive
to local changes in output and more responsive to world changes in output.

Exercise 1 Suppose that the two countries have different discount rates β 6= β ∗ .
(i) Derive the equation that determines market clearing in the goods market at
date 1;
(ii) Derive the equilibrium interest rate in the case y1 = y
1∗ = y
2 = y
2∗ ;

(iii) Derive the pattern of borrowing and lending in this case;

y∗
(iv) In the general case show that if β1∗ y2∗ <
β1 yy21 the equilibrium interest rate
1
has to satisfy
∗
1
y
2 1
y
2
∗ ∗ <1+r <

β
y
1 β
y
1
(Hint: a graphical argument should work fine).

Cite as: Guido Lorenzoni, course materials for 14.54 International Trade, Fall 2006.

MIT OpenCourseWare (http://ocw.mit.edu/), Massachusetts Institute of Technology. Downloaded on [DD Month YYYY].