Intro Macro, ECON10003

Lecture 23: Balance of Payments - Part B

Nahid Khan and Lawrence Uren

University of Melbourne

16 October, 2018

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Introduction: Outline

Today’s lecture: some topics in international economics

I Capital Flows and Interest Rates
I Intertemporal approach to the current account
Reading:
I Chapter 16 of Bernanke, Olekalns and Frank
Lecture 24: Review
I 9am: Economic growth
I 11am: International economics
I 2:15pm: Measurement and a Simple Keynesian Model
I 4:15pm: Aggregate Demand and Aggregate Supply

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Capital Inflow and Real Interest Rates

Diagram: Capital Inflow and Real Interest Rates

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Differences Between Domestic and World Interest Rates

Should expect the long run differences between domestic and world
interest rates to be small
I Suppose domestic interest rate exceeds world interest rate
I Increase demand for domestic assets
I Increase in price of domestic assets
I As price of asset rises, rate of return declines
Exceptions
I Some countries are inherently riskier

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Net Saving, Investment and Capital Flows

Recall, in an open economy

S − I = NX

where S is national savings, I is investment and NX is net exports

but NX equals the negative of capital inflow

S + KI = I

Investment undertaken equals domestic saving plus net captial

inflow

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Net Saving, Investment and Capital Flows

Diagram: Net Saving, Capital Flows and Investment

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Intertemporal Approach to the Current Account

I International lending or borrowing provides access to another

market that allows gains from trade
I Countries borrow when they are willing to consume or invest
more than they currently produce
I Countries lend when they are willing to consume or invest less
than they currently produce

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Intertemporal Approach to Current Account

Diagram: Savings and Investment in Two Countries - Autarky and

Trade Equilibrium

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Intertemporal Approach to Current Account

I Gains from trade in an intertemporal setting

I Country with high rate of return on investment receives
greater investment
I Country with lower rate of return on investment reduces
investment
I This is an improved allocation: the projects undertaken have a
higher rate of return

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Intertemporal Approach to Current Account

I Still potential role for distributional effects

I Savers in the high interest rate economy face lower interest
rates in trade equilibrium

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Intertemporal Approach to Current Account

Case Study: Norway and North Sea Oil Reserves

I Norway and the discovery of oil in early 1970s
I Current account deficits in the short run to finance investment
to access oil reserves
I Current account surpluses in the long run to repay initial
investment

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Intertemporal Approach to Current Account

Case Study: Japan and Sweden during WWI

I Countries involved in wars have a large increase in demand for
output
I Countries can borrow from abroad by running a current
account deficit
I During WWI, (neutral countries) Japan and Sweden, had less
need for increased spending - they lent resources to the rest of
the world and ran current account surpluses during this period

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Intertemporal Approach to Current Account

This story coincides with the Lawson Doctrine - Pitchford Thesis

I Current account position reflects decisions by individuals or
firms that generate gains from trade
What could go wrong with this story?
I Markets may not operate efficiently at all times, and large
current account deficits may hold some risk

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