HOME 1.

Important: Submit on lecture or at the start of first seminar, late submission is subject to 50% discount.
Only 3 problems (out of total 5) will be graded and included into the final mark, with equal points each.
Problems to be graded are chosen randomly, with more weight assigned to those submitted by fewer people.

Problem 1.
a) Why do countries with higher Current Account deficit tend to be affected more adversely by the recent world economic crisis?

High Current Account deficit means that the country imports much more than it exports, i.e. it buys more from foreigners that it sells to them. The country must somehow finance this CA deficit and it can do it only by borrowing or international sales of domestic assets (since Export revenues are not enough to cover the Imports), i.e. by capital inflows from abroad. The recent history shows that countries with high CA deficits are more vulnerable to economic turmoil and there are several reasons for this. First of all, the increase in the indebtness of the private and public sector of the capital-importing economy may turn to be unsustainable leading to bankruptcy. Secondly, this high inflow of foreign capital in the country may lead to unsustainable asset price bubbles (in the countries, where the CA deficit is largely financed by the sales of domestic stocks) which will surely collapse in some time. Finally, if the country is running a high CA deficit it becomes more vulnerable to currency shocks.

b) What can a government of such country do to correct CA deficit? Use only the concepts that we have learned in the course so far.

As we know, Y = C + I + G + CA => CA = Y – C – G – I = (Y – C – T) + (T – G) – I = Sp – budget deficit – I.
We see from here, that in order to reverse the CA deficit and reduce the growth of foreign indebtness by domestic residents, the government can reverse the budget deficit and turn it into the surplus, by increasing taxes and cutting public spending. Alternatively, it can try to encourage households to save more and consume less (thus, increasing Sp), however, this channel is not as straightforward as the first one, since it implies changing preferences.
It should be noted, however, that the equation CA = Sp – budget deficit – I is just an accounting identity with no underlying theory of economic behavior and evaluating the links may be difficult. Thus, for instance, the Reagan’s example of 1980’s shows exactly that the cut in budget deficit corresponds practically one-for-one to the decrease in CA deficit and private savings and investments did not change. However, the EU example (governments had to reduce budget deficits in order to enter the EU) shows that the decrease in budget deficit had no effect on CA deficit with private savings and investments shrunk. One of the possible reasons for this finding will be discussed in point (c).

c) Assume citizens in a country are rational individuals with perfect foresight. Does this fact help or hinder the government actions from part b)?

This fact is likely to hinder the government actions from part (b) and the reason for this is the Ricardian Equivalence. Ricardian Equivalence argues that when the government lowers taxes and raises its deficit, consumers anticipate that they will face higher taxes in future since the government will need to finance the resulting debt. In anticipation they raise their own savings, in order to smooth consumption, and this change offsets the fall in government saving. Conversely, higher taxes will lead to the decrease in private savings. Thus, if actions outlined in point (b) will be implemented (cut government spending and raised taxes), individuals will reduce their savings leaving the Current Account deficit unchanged or at least not reduced to the initially planned level (this is what happened in EU in the late 90’s). Assuming that citizens in a country are rational and have perfect foresight is necessary for the RE to hold. Thus,