EC916 Global Finance
EC916 Global Finance
For students taking EC916 Global Finance at Warwick. The models below follow the lectures and their notation, and each lists its assumptions under the controls.
For students taking EC916 Global Finance at Warwick. The models below follow the lectures and their notation, and each lists its assumptions under the controls.
Choose a shock or a model and move the sliders; each chart redraws, and the text under it explains what changed.
A household lives for two periods and can borrow or lend at the world interest rate r*. The chart shows its endowment E, its budget line and the point O it chooses. The part of today’s income it does not consume is the current account, CA₁ = Q₁ − C₁.
Whether the country borrows or lends depends on how the world rate compares with its autarky rate, the interest rate at which households would choose to consume exactly their own income in each period. If the world rate is lower, the country borrows and runs a current account deficit today; if it is higher, the country lends. The readout also shows the gain from being open: the equal rise in consumption in both periods that would make autarky as good.
The defaults are the lecture’s example (Q₁ = 80, Q₂ = 120, β = 0.96, r* = 4%): the autarky rate is 56%, the country borrows about 20, and being open is worth about 2% of consumption. Try Q₁ = Q₂ = 100 and the current account is almost balanced, because β(1 + r*) is close to one. Then go back to the defaults and lower σ: the autarky rate rises further above the world rate and the gain grows.
A small open economy can borrow and lend at the world interest rate r*. With log utility and β(1 + r*) = 1 households want the same consumption in both periods, so how an output shock shows up in the current account depends on how long it lasts. The chart follows the lecture’s figures: A is the endowment, B the chosen point, and the primes mark them after the shock.
A temporary fall in output is financed: consumption falls by about half as much, and the current account absorbs the rest. A permanent fall is adjusted to: consumption falls one for one and the current account does not move. News that output will be higher tomorrow raises consumption today and worsens the current account, so good news can cause a deficit.
Try the temporary shock with Q₁ = Q₂ = 100: output falls by 20, consumption by only 10.2, and the current account goes from balance to a deficit of 9.8. Then switch to the permanent shock, and consumption falls by the full 20.
With investment, the current account is saving minus investment. Firms invest until the return on capital equals 1 + r, and households save what they do not consume, so investment falls and saving rises with the interest rate. At the world rate r* the gap between the two schedules is the current account; where they cross is the rate a closed economy would have.
A temporary rise in productivity today shifts saving to the right and improves the current account. News of higher productivity tomorrow shifts investment to the right and saving to the left, so the current account worsens, as after a large oil discovery. The Gains from openness view shows why opening up pays: the country can invest where the return equals r* and borrow or lend to smooth consumption.
Try the default news shock: the current account worsens by 7.8, while a closed economy’s interest rate would rise from 10.1% to 21.1%. In the gains view the defaults give a welfare gain of 2.47% of consumption, about half from borrowing and lending and half from investing more.
The debt ratio grows with the interest rate on the debt and shrinks as the economy grows, so what matters is the gap r − g. When r is above g, debt keeps rising unless the government runs a large enough primary surplus; when r is below g, it can fall even while the government runs a small deficit. The readout gives the primary balance that would hold debt at today’s level.
Switch on shocks to draw 2,000 paths in which growth and the interest rate move at random each year; the shaded bands show how wide the range of outcomes gets. The Debt limit view adds fiscal fatigue (Ghosh et al., 2013): the primary surplus rises with debt, but the response fades at high debt. Debt then settles at a stable ratio d*, and beyond a limit d** it explodes. The distance from today’s debt to d** is the fiscal space.
Try r = 1%, g = 3% and a primary deficit of 1% of GDP: debt falls from 100% to about 78% of GDP in 30 years. In the Debt limit view, raise r from 3% to 5%: the limit falls from about 213% to 189% of GDP, and at 6% no debt level is stable.
A government pays for its deficit by printing money, while the central bank holds the exchange rate fixed by selling reserves. Reserves fall year after year, but speculators do not wait for them to run out. They strike when the rate that would hold without the peg, the shadow rate, reaches the peg, and they take the remaining reserves all at once.
This is the first-generation crisis model of Krugman (1979) and Flood and Garber (1984). The three views show reserves, the exchange rate against its shadow rate, and the seignorage Laffer curve that sets money growth once the peg has gone.
Try doubling the deficit to 16. The attack comes within the first year, although reserves alone would last almost four years.
Uncovered interest parity says the home currency must be expected to weaken by as much as home interest rates exceed foreign ones. Solved forward, today’s exchange rate depends on the whole expected path of interest differentials, not only on today’s rates.
News therefore moves the exchange rate at once. An announced rate rise strengthens the home currency on the day of the announcement, by as much as a surprise rise of the same size and persistence would; the currency then weakens gradually as the differential runs down. The lecture uses the same logic for Dornbusch overshooting and for the 2013 taper tantrum.
Try a foreign rate rise announced four quarters ahead: the home currency weakens by 1.25% as soon as the news arrives, before any rate has moved, much as emerging-market currencies fell in May 2013.