Macroeconomía II 2022

El Colegio de México
Dr. Stephen McKnight

Topic 5: Uncertainty & The

Current Account
 Class Outline

5.1 Introduction and Aims

5.2 The Great Moderation
5.3 A Small Open Economy Model with Uncertainty
5.4 Complete Asset Markets
5.5 Summary
5.6 Mid-Term Exam
 5.1 Introduction & Aims
• Over the last few weeks, we have studied the response of the current account to
changes in fundamentals that are known with certainty
• The real world, however, is an uncertain place
• Some periods display higher macroeconomic volatility than others
• A natural question, therefore, is how the overall level of uncertainty affects the
macroeconomy, and, in particular, the current account
• To motivate the analysis, we begin by documenting that between the mid 1980s and
the mid 2000s the United States experienced a period of remarkable aggregate
stability, known as the Great Moderation, which coincided with the emergence of
large U.S. current account deficits
• We expand our one-good, small-open endowment economy model to introduce
uncertainty about the size of the endowment the household will receive in period 2
• In the presence of uncertainty there are multiple “states of nature” (or “states of
the world”)
• This modification allows us to understand the effect of changes in the aggregate
level of uncertainty on consumption, saving, the trade balance, and the current
account
• We begin by considering the implications of uncertainty in the presence of
incomplete asset markets
• Under incomplete asset markets, the only financial instrument available to
households is a risk-free bond whose payoff is the same in the good and bad
states of nature
• We will show that under incomplete asset markets, an increase in uncertainty
causes an increase in precautionary saving and improvements in the trade balance
and the current account of small open economies
• We will then show how the results change in the presence of complete asset
markets
• Under complete asset markets, state contingent claims are available to
households
• These contingent claims are risky assets: they have period 2 payoffs that vary
according to the state of nature
• i.e., the household only receives (pays) one unit of output in period 2 if the state
of nature occurs but receives (pays) nothing in all other states
• We will show that under complete asset markets, the positive relationship between
the level of uncertainty and the current account disappears
 Reading

Schmitt-Grohe, Uribe, and Woodford (2021):

Chapter 5
 5.2 The Great Moderation

• The volatility of U.S. output declined significantly starting in the early 1980s
• This phenomenon has become known as the Great Moderation
• The next slide illustrates this point by depicting the quarterly growth rate of real per
capita GDP in the United States over the period 1947:Q2 to 2017:Q4
• It shows that output growth has been much smoother in the post-1984 subsample
than it was in the pre-1984 subsample
• A commonly used measure of volatility in macroeconomic data is the standard
deviation
• According to this statistic, postwar U.S. output growth became half as volatile after
1983
• The standard deviation of quarter-to-quarter real per capita output growth was
1.2% over the period 1947Q1 to 1983Q4 and only 0.6% over the period 1984Q1 to
2017Q4
Causes of the Great Moderation?

• Economists have put forward three alternative explanations of the Great Moderation
1. Good luck
2. Good policy
3. Structural change

The good-luck hypothesis

• By chance, starting in the early 1980s the U.S. economy has been blessed with smaller shocks

The good-policy hypothesis

1. Good monetary policy: aggressive low inflation policy started by the Volcker Fed and
continued by the Greenspan Fed
2. Good regulatory policy: early 1980s regulation Q (or Reg Q) was abandoned

The structural change hypothesis

• It maintains that the Great Moderation was in part caused by structural change, particularly in
inventory management and in the financial sector
• These technological developments, allowed firms to display smoother flows of production,
distribution, sales, employment, and inventories, thereby reducing the amplitude of the
business cycle
• During the period 1947Q1 – 1983Q4 the United States experienced on average
positive current account balances of 0.34% of GDP
• Starting in the early 1980s, large current account deficits averaging 2.8% of GDP
opened up
• The emergence of persistent current account deficits in the United States
coincided with the beginning of the Great Moderation in 1984
• Is the timing of the Great Moderation and the emergence of protracted current
account deficits pure coincidence, or is there a causal connection between the two?
• To address this issue, we will explore the effects of changes in output uncertainty
on the trade balance and the current account using our intertemporal endowment
model of the current account
 5.3 A Small Open Economy Model with
Uncertainty
Assumptions:

• We extend our deterministic 2-period small-open economy endowment model to

its stochastic (that is, with uncertainty) version
• The main difference is that in period 2 two states of nature are possible: (i) good /
high (H) endowment case; and (ii) bad /low (L) endowment case
• The actual realization of any of these two states of nature is uncertain (from the
perspective of period 1)
• These two states of nature:
(a) Occur randomly, according to a specified (i.e., known to households) probability
distribution. We assume that each state occurs with equal probability of 1/2
(b) They differ only in their associated endowment levels in period 2
• In the good state H, the household receives a high endowment of 𝑄2 + 𝜎
• In the bad state L, the household receives a low endowment of 𝑄2 − 𝜎
• We will initially assume that the households can only trade risk-free bonds
(incomplete asset markets)

Intuition:
• Facing an uncertain income in period 2, households are likely to engage in
precautionary saving in period 1
• This would allow them to hedge against a bad income realization in period 2
• Thus, consumption should fall in period 1
• Since the period 1 endowment is unchanged, the trade balance must improve

Implication:
• If this intuition is right, the decline in income uncertainty observed during the
Great Moderation should lead to an elevation in current account deficits
Baseline: The Economy without Uncertainty

• We initially consider an economy in which the stream of endowments (output) is known

with certainty and is constant over time:
𝑄1 = 𝑄2 = 𝑄

• Households maximize lifetime utility 𝑈, which depends on period consumption levels

𝐶:
𝑈 = 𝑢 𝐶1 + 𝛽𝑢 𝐶2
⇒ 𝑈 = ln 𝐶1 + ln 𝐶2

• For simplicity we assume that the world interest rate is zero (𝑟 ∗ = 0) and initial asset
holdings in the economy are zero (i.e., 𝐵0 = 0) so that the current account equals the
trade balance. These assumptions simplify the budget constraints of the household
• The period 1 budget constraint is given by:
𝐶1 + 𝐵1 − 𝐵0 = 𝑟0 𝐵0 + 𝑄1
⇒ 𝐶1 + 𝐵1 = 𝑄

• The period 2 budget constraint is given by:

𝐶2 + 𝐵2 − 𝐵1 = 𝑟1 𝐵1 + 𝑄2
⇒ 𝐶2 + 𝐵2 − 𝐵1 = 𝑄
• The transversality condition is 𝐵2 = 0
• Combining the period 1 and 2 budget constraints and imposing the transversality
condition yields the following intertemporal budget constraint:
𝐶1 + 𝐶2 = 2𝑄 (1)

• The household’s maximization problem is

max ln 𝐶1 + ln 𝐶2
𝐶1 ,𝐶2

• subject to the intertemporal budget constraint (1)

• Using the intertemporal budget constraint to eliminate 𝐶2 from the lifetime utility
function, then the household maximization problem reduces to:

max ln 𝐶1 + ln 2𝑄 − 𝐶1 .
𝐶1

• The F.O.C for this unconstrained optimization problem yields the consumption Euler
equation:
𝜕𝑈 1 1
= − = 0,
𝜕𝐶1 𝐶1 2𝑄 − 𝐶1

⇒ 𝐶1 = 𝑄
• The trade balance is zero: 𝑇𝐵1 = 𝑄 − 𝐶1 = 0
• and the current account is in balance: 𝐶𝐴1 = 𝑇𝐵1 = 0

Intuition for the Baseline:

• Output is perfectly smooth (𝑄1 = 𝑄2 = 𝑄) in this economy, so consumption is

also perfectly smooth (𝐶1 = 𝐶2 = 𝑄)

• No need for households to use the current account to smooth consumption over
time because the endowment stream is already perfectly smooth
Introducing Uncertainty

• Suppose now that the period 1 endowment continues to be 𝑄, but that the period
2 endowment 𝑄2 is not known with certainty in period 1
• Specifically, we assume that with probability 1/2 the household receives a positive
endowment shock in period 2 equal to 𝜎 > 0, and that with equal probability the
household receives a negative endowment shock in the amount of −𝜎
• Thus:
𝑄 + 𝜎 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1/2
𝑄2 = ቊ
𝑄 − 𝜎 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 1/2

• Relative to the economy without uncertainty, this is a mean preserving increase

in uncertainty in the sense that the expected value 𝐸 of the endowment in period
2:
1 1
𝐸 𝑄2 = 𝑄 + 𝜎 + 𝑄 − 𝜎 = 𝑄
2 2

• equals the endowment that the household receives in period 2 in the economy
without uncertainty
• The parameter 𝜎 measures the degree of uncertainty (i.e., the standard deviation
of the period 2 endowment)
• To see this, first note that the variance is the expected value of squared deviations
of output from its mean
• In the good state of nature H, the deviation of output from its mean (𝑄) is:
𝑄+𝜎−𝑄 =𝜎
• In the bad state of nature L, the deviation of output from its mean is:
𝑄 − 𝜎 − 𝑄 = −𝜎
• Therefore, the variance is:
1 1
𝑉𝑎𝑟 𝑄2 = 𝐸 𝑄2 − 𝐸(𝑄2 ) = 𝑄 + 𝜎 − 𝑄 + 𝑄 − 𝜎 − 𝑄 2
2 2
2 2
𝜎 2 (−𝜎) 2
= + = 𝜎2
2 2
• The standard deviation is the square root of the variance. Therefore, the standard
deviation of 𝑄2 is

𝑉𝑎𝑟(𝑄2 ) = 𝜎2 = 𝜎

• Therefore, the standard deviation of the endowment in period 2 is given by 𝜎

• It follows that the larger is 𝜎, the more volatile the period 2 endowment will be
• We must specify how households value uncertain consumption paths
• We will assume that households care about the expected value of utility
• The individual’s lifetime expected utility on date 1 is given by:

1 1
𝑈1 = ln 𝐶1 + ln 𝐶2 (𝐻) + ln 𝐶1 + ln 𝐶2 (𝐿)
2 2
1 1
⇒ 𝑈1 = ln 𝐶1 + ln 𝐶2 (𝐻) + ln 𝐶2 (𝐿)
2 2
⇒ 𝑈1 = ln 𝐶1 + 𝐸 ln 𝐶2

• Note that this preference formulation encompasses the preference specification we

used in the absence of uncertainty
• This is because when 𝐶2 is known with certainty, then 𝐸 ln 𝐶2 = ln 𝐶2
• The period 1 budget constraint is given by (it is the same as with certainty):

𝐶1 + 𝐵1 = 𝑄
• However, now we have TWO period 2 budget constraints (one for each state of
nature)
• For the good state of nature H, the period 2 budget constraint is:

𝐶2 (𝐻) + 𝐵2 − 𝐵1 = 𝑄2 (𝐻)
⇒ 𝐶2 (𝐻) − 𝐵1 = 𝑄 + 𝜎

• after imposing the transversality condition 𝐵2 = 0

• For the bad state of nature L, the period 2 budget constraint is:

𝐶2 𝐿 + 𝐵2 − 𝐵1 = 𝑄2 (𝐿)
⇒ 𝐶2 𝐿 − 𝐵1 = 𝑄 − 𝜎

• after setting 𝐵2 = 0
• Combining the period 1 budget constraint with each period 2 budget constraint,
yields the intertemporal budget constraint for each state of nature:

𝐶1 + 𝐶2 𝐻 = 2𝑄 + 𝜎

𝐶1 + 𝐶2 𝐿 = 2𝑄 − 𝜎
• Using each intertemporal budget constraint to eliminate 𝐶2 (𝐻) and 𝐶2 (𝐿) from the
lifetime utility function, then expected lifetime utility is given by:
1 1
𝑈1 = ln 𝐶1 + ln 𝐶2 (𝐻) + ln 𝐶2 (𝐿)
2 2
1 1
⇒ 𝑈1 = ln 𝐶1 + ln 2𝑄 + 𝜎 − 𝐶1 + ln 2𝑄 − 𝜎 − 𝐶1
2 2

• The household chooses 𝐶1 to maximize utility

• The F.O.C. associated with this problem is:
1 1 1
− − =0
𝐶1 2 2𝑄 + 𝜎 − 𝐶1 2 2𝑄 − 𝜎 − 𝐶1

1 1 1 1
⇒ = + (2)
𝐶1 2 2𝑄 + 𝜎 − 𝐶1 2𝑄 − 𝜎 − 𝐶1

• Equation (2) is the consumption Euler equation under uncertainty

• LHS = marginal utility of consumption in period 1
• RHS = the expected marginal utility of consumption in period 2
• Is the optimal consumption level under certainty 𝐶1 = 𝐶2 = 𝑄 also optimal under
uncertainty?
• Let’s check this by setting 𝐶1 = 𝑄 into the Euler equation:
1 1 1 1
= +
𝑄 2 2𝑄 + 𝜎 − 𝑄 2𝑄 − 𝜎 − 𝑄

1 1 1 1
⇒ = +
𝑄 2 𝑄+𝜎 𝑄−𝜎

𝑄2
⇒1= 2
𝑄 − 𝜎2
• which is impossible, given that 𝜎 > 0
• We have thus shown that 𝐶1 ≠ 𝑄
• That is, a mean preserving increase in uncertainty induces households to choose a
different level of period 1 consumption than the one they would choose under
certainty
• The next Figure provides a graphical representation of this result
• It plots with a solid line the marginal utility of period 1 consumption as a function
of 𝐶1 i.e., the LHS of the Euler equation (2)
• Suppose 𝐶1 = 𝑄. Then the marginal utility of period 1 consumption is equal to 1/𝑄
(point A in the figure)
• In this case consumption in period 2 is either (𝑄 − 𝜎) or (𝑄 + 𝜎) and the marginal
utility in period 2 is either at point B, where 1/(𝑄 − 𝜎), or point C, where 1/(𝑄 + 𝜎)
• The expected marginal utility in period 2 is then given by point D, where:
1 1
+
2(𝑄 − 𝜎) 2(𝑄 + 𝜎)

• Point D is above point A (because the marginal utility is convex), therefore when 𝐶1 = 𝑄
the marginal utility of period 1 consumption is below the expected marginal utility of
period 2 consumption
• Therefore, we have shown that if we set 𝐶1 = 𝑄, then the LHS of the Euler equation (2)
is less than the RHS:
1 1 1 1 1 1 1
< + = +
𝐶1 2 2𝑄 + 𝜎 − 𝐶1 2𝑄 − 𝜎 − 𝐶1 2 𝑄+𝜎 𝑄−𝜎

• In other words, if the consumer chose 𝐶1 = 𝑄, then the marginal utility of consumption
in period 1 would be smaller than the expected marginal utility of consumption in period
2
• The household would be better off consuming less in period 1 and more in period
2!
• By inspection of the Euler equation (2), we can observe that the LHS is decreasing
in 𝐶1 and the RHS increasing in 𝐶1 :

1 1 1 1
= +
𝐶1 2 2𝑄 + 𝜎 − 𝐶1 2𝑄 − 𝜎 − 𝐶1

• It follows that the that the optimal consumption choice in period 1 that satisfies the
Euler equation (2) is:
𝐶1 < 𝑄

• This means that an increase in uncertainty induces households to consume less and
save more
• By saving more in period 1, households avoid having to cut consumption by too
much in the bad state of nature of period 2
• This type of saving is known as precautionary saving
Uncertainty, the Trade Balance, and the Current Account

• Recall that under certainty the trade balance and current account are balanced with
𝐵0 = 0
• An increase in uncertainty causes an improvement in the trade balance and the
current account:
𝐶𝐴1 = 𝑇𝐵1 = 𝑄 − 𝐶1 > 0

• Intuitively, in response to an increase in uncertainty, households use the current

account as a vehicle to save in period 1

• Viewed through the lens of this model, the reduction in output volatility that came
with the Great Moderation should have contributed to the observed deterioration
of the U.S. current account
 5.4 Complete Asset Markets

• In the economy studied so far, households face uninsurable income risk

• This is because the only financial instrument available to them under incomplete
asset markets is a risk-free bond whose payoff in period 2 is the same in both the
good and bad states of nature
• Households would like to buy a portfolio of assets that pays more in the state of
nature in which the endowment is low than in the state of nature in which the
endowment is high
• We now introduce such a possibility by assuming the existence of state-contingent
claims
• In this environment, households do not need to rely on precautionary saving to
cover themselves against the occurrence of the low-endowment state
State Contingent Claims

• Suppose that in period 1 there exists the following two assets, known as state
contingent claims:
1. An asset 𝐵𝐻 that pays in period 2, one unit of goods in the good state H and zero
in the bad state of nature L. Its price is 𝑃𝐻
2. Another asset 𝐵𝐿 that pays one unit of goods in the bad state L and zero in the
good state of nature H. Its price is 𝑃𝐿
• This economy is said to have complete asset markets, because households can buy
asset portfolios with any payoff pattern across states in period 2
• If the household wishes to have a portfolio that pays 𝑥 units of goods in the good
state of nature and 𝑦 units in the bad state of nature, then it must simply purchase
𝑥 units of the asset that pays in the good state (𝐵𝐻 = 𝑥) and 𝑦 units of the asset
that pays in the bad state (𝐵𝐿 = 𝑦)
• This portfolio costs in period 1:
𝑃𝐻 𝑥 + 𝑃𝐿 𝑦

• This was not possible in the incomplete asset economy, because with a risk-free
bond, households are restricted to buy asset portfolios with the same payoff in
period 2 regardless of the state of nature that occurs
• The quantities 𝐵𝐻 and 𝐵𝐿 could be positive or negative
• For example, the household could sell contingent claims that pay in the good state
(𝐵𝐻 < 0) and buy contingent claims that pay in the bad state (𝐵𝐿 > 0)

Redundancy of Additional Assets

• The existence in period 1 of one state contingent claim for each possible state of
nature in period 2, makes any other asset redundant, in the sense that its payoff can
be replicated by an appropriate portfolio of state contingent claims
• Consider, for example, a risk-free bond, that was available to households in the
incomplete asset market economy of the previous section
• A risk-free bond is an asset that costs one unit of good in period 1 and pays 1 + 𝑟1
units of good in every state of period 2, where 𝑟1 is the risk-free interest rate
• Consider now constructing a portfolio of contingent claims that has the same
payoff as the risk-free bond, i.e., a portfolio that pays 1 + 𝑟1 in each state of period
2
• This portfolio must contain 1 + 𝑟1 units of each of the two contingent claims
• The price of this portfolio in period 1 is:
(𝑃𝐻 +𝑃𝐿 )(1 + 𝑟1 )
• This portfolio price must equal the price of the risk-free bond, namely 1,
otherwise a pure arbitrage opportunity would exist
• Thus, we have that:
(𝑃𝐻 +𝑃𝐿 ) 1 + 𝑟1 = 1
1
⇒ 1 + 𝑟1 = 𝐻 (3)
𝑃 + 𝑃𝐿

• Thus, the gross risk-free interest rate is the inverse of the price of a portfolio that
pays one unit of good in every state of nature of period 2
Household’s Optimization Problem

• The period 1 budget constraint of the household is given by:

𝐶1 + 𝑃𝐻 𝐵𝐻 + 𝑃𝐿 𝐵𝐿 = 𝑄

• In period 2, there is a budget constraint for each state of nature 𝐻 and 𝐿

• For the good state of nature, the period 2 budget constraint is:

𝐶2 𝐻 = 𝑄 + 𝜎 + 𝐵𝐻

• For the bad state of nature, the period 2 budget constraint is:

𝐶2 𝐿 = 𝑄 − 𝜎 + 𝐵𝐿

• As before, each state of nature has the same probability of occurrence (i.e., 1/2 )
• Using the period 1 budget constraint to eliminate 𝐶1 and the period 2 budget constraints to
eliminate 𝐶2 (𝐻) and 𝐶2 (𝐿), the individual’s lifetime expected utility on date 1 is given by:
1 1
𝑈1 = ln 𝐶1 + ln 𝐶2 (𝐻) + ln 𝐶2 (𝐿)
2 2
1 1
⇒ 𝑈1 = ln 𝑄 − 𝑃 𝐵 − 𝑃 𝐵 + ln 𝑄 + 𝜎 + 𝐵 + ln 𝑄 − 𝜎 + 𝐵𝐿
𝐻 𝐻 𝐿 𝐿 𝐻
2 2

• The household chooses 𝐵𝐻 and 𝐵𝐿 to maximize utility

• The F.O.C.’s are:
𝑃𝐻 1
= (4)
𝐶1 2𝐶2 (𝐻)

𝑃𝐿 1
= (5)
𝐶1 2𝐶2 (𝐿)

• Equations (4) and (5) are the intertemporal Euler equations relating to state contingent
claims rather than a risk-free bond
• The LHS of (4) is the welfare cost of purchasing in period 1 a state contingent claim that
pays one unit of consumption in the good state of nature in period 2
• Why? The price of such an asset is 𝑃 𝐻 units of period 1 consumption. In turn, each unit of
period 1 consumption yields 1/𝐶1 units of utility, because, with log preferences, 1/𝐶1 is the
marginal utility of consumption
• So the total utility cost in period 1 of a state contingent claim that pays one unit of
𝑃𝐻
consumption in the good state of nature in period 2 is
𝐶1
• The household equates this cost to the expected utility of an additional unit of
1
consumption in the good state of nature in period 2, given by
2𝐶2 (𝐻)
• The second optimality condition (5) has a similar interpretation
• We can rearrange equations (4) and (5):
𝐻
𝐶1
𝑃 =
2𝐶2 (𝐻)

𝐶1
𝑃𝐿 =
2𝐶2 (𝐿)

• where the marginal rate of substitution between consumption in period 1 and state-
contingent consumption in period 2 is equal to the relative price of goods in each
state in period 2 in terms of goods in period 1
Note

• Under incomplete asset markets, we had one optimality condition, the Euler
equation given by (2)
• Under complete asset markets, we have two optimality conditions (4) and (5)
• The reason is that under complete asset markets the household can buy as many
independent assets as there are states of nature (in our example two)
• Whereas with incomplete asset markets the household has access to fewer assets
than states (one asset in an environment with two states of nature)
Free International Capital Mobility

• As in the incomplete asset economy, we assume that there is free international

capital mobility
• This means that the domestic prices of the state-contingent claims must be equal to
the corresponding world prices
• Let 𝑃𝐻∗ and 𝑃𝐿∗ denote the world prices of the state contingent claims that pay in
the good and bad states of nature, respectively
• Under free capital mobility, it follows that 𝑃𝐿 = 𝑃𝐿∗ and 𝑃𝐻 = 𝑃𝐻∗
• and similar to the pricing equation (3), the world interest rate must be given by (no-
arbitrage condition):

1
1 + 𝑟∗ = (6)
𝑃𝐻∗ + 𝑃𝐿∗

• Assuming for simplicity as we did in the economy with incomplete asset markets
that the world interest rate is zero (𝑟 ∗ = 0) gives:
𝑃𝐻∗ + 𝑃𝐿∗ = 1
Assumption: Foreign Investors Make Zero Expected Profits

• We assume that foreign investors make zero profits on average

• The revenue of a foreign investor who sells in period 1 𝐵𝐻 and 𝐵𝐿 units of state contingent
claims is 𝑃 ∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿
• Suppose that the foreign investor uses these funds to buy risk-free bonds
• In period 2, the foreign investor receives from this investment:
(1 + 𝑟 ∗ )(𝑃∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 )

• in both states of nature

• But she must pay 𝐵𝐻 if the state is good and 𝐵𝐿 if the state is bad
• So her profits in the good state of nature are (with probability 1/2):
1 + 𝑟 ∗ 𝑃 ∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − 𝐵𝐻

• and profits in the bad state are (with probability 1/2):

1 + 𝑟 ∗ 𝑃 ∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − 𝐵𝐿

• Thus, the expected profits of the foreign investor is:

1 1
1 + 𝑟 ∗ 𝑃 ∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − 𝐵𝐻 + 1 + 𝑟 ∗ 𝑃∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − 𝐵𝐿
2 2
 1 ∗ ∗𝐻 𝐻 ∗𝐿 𝐿 𝐻
1
1+𝑟 𝑃 𝐵 +𝑃 𝐵 −𝐵 + 1 + 𝑟 ∗ 𝑃∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − 𝐵𝐿
2 2

𝐵𝐻 𝐵𝐿
⇒ 1+ 𝑟∗ 𝑃∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − −
2 2

• The assumption that the foreign investor makes zero expected profits on any portfolio
𝐵𝐻 , 𝐵𝐿 means:
𝐵 𝐻 𝐵 𝐿
1 + 𝑟 ∗ 𝑃∗𝐻 𝐵𝐻 + 𝑃 ∗𝐿 𝐵𝐿 − − =0
2 2
1 1
⇒ 1 + 𝑟 ∗ 𝑃∗𝐻 − 𝐵𝐻 + 1 + 𝑟 ∗ 𝑃∗𝐿 − 𝐵𝐿 = 0
2 2

• which implies:
1 1
1+ 𝑟∗ 𝑃∗𝐻 = ; 1+ 𝑟∗ 𝑃 ∗𝐿 =
2 2

• Finally, assuming as we did in the economy with incomplete asset markets that the world
interest rate is zero (𝑟 ∗ = 0) gives:
1
𝑃 ∗𝐻 = 𝑃 ∗𝐿 =
2
Equilibrium in the Complete Asset Market Economy

• From the Euler equations (4) and (5):

𝑃𝐻 1 𝑃𝐿 1
= ; =
𝐶1 2𝐶2 (𝐻) 𝐶1 2𝐶2 (𝐿)

1
• We impose 𝑃 ∗𝐻 = 𝑃 ∗𝐿 = to get:
2
𝐶1 = 𝐶2 𝐻 = 𝐶2 𝐿 (7)

• Thus, complete asset markets allow households to completely smooth consumption across
time and across states of nature!
• Combining (7) with the period 2 budget constraints gives:
𝐵𝐻 = 𝐶1 − 𝑄 − 𝜎 (8)
𝐵𝐿 = 𝐶1 − 𝑄 + 𝜎 (9)

• Inserting (8) and (9) into the period 1 budget constraint yields 𝐶1 = 𝑄
• Thus, it follows from (7):
𝐶1 = 𝐶2 𝐻 = 𝐶2 𝐿 = 𝑄
• And inserting 𝐶1 = 𝑄 into (8) and (9) yields:

𝐵𝐻 = −𝜎
𝐵𝐿 = 𝜎

• Thus, the household takes a short position (borrows) in contingent claims that pay
in the good state of nature and a long position (saves) in claims that pay in the bad
state of nature
• In this way, households can transfer resources from the good state to the bad state
of nature in period 2, which allows them to smooth consumption across states
• Notice the difference compared to incomplete asset markets
• With a risk-free bond, households cannot transfer resources across states, because
the financial instruments to do so are unavailable
• Instead, to self-insure, households in period 1 must engage in precautionary saving
to transfer resources to both states in period 2 through the single bond traded in
the market
• This is an inferior option because it forces households to transfer resources from
period 1 to the good state in period 2, where they are not needed
• The trade balance and current account are balanced
𝐶𝐴1 = 𝑇𝐵1 = 𝑄 − 𝐶1 = 0

• Thus, under complete financial markets precautionary saving is zero and the link
between the level of uncertainty and the current account disappears
• Thus, the main result of the previous section, namely, that a decrease in uncertainty
leads to a deterioration in the current account relies on the assumption that
financial markets are incomplete
• It is therefore natural to ask whether reality is better approximated by the
assumption of complete asset markets or by the assumption of incomplete
markets?
• Domestic financial markets could be incomplete for various reasons
• As we will discuss later in the course, there may exist moral hazard and incomplete
contracts that make it impossible for any country to fully insure itself against all the
risks it faces
• Although with complete asset markets the current account is zero independently
of the degree of uncertainty 𝜎, there can be significant amount of international
borrowing and lending in this economy
• Specifically, even though the country’s net international asset position is zero:
𝐵𝐻 + 𝐵𝐿 = 0

• the gross positions, 𝐵𝐻 and 𝐵𝐿 , are not

• We saw that in equilibrium the country saves in bonds that pay in the bad state of
nature 𝐵𝐿 = 𝜎 > 0 and borrows in bonds that pay in the good state of nature
𝐵𝐻 = −𝜎 < 0
• The gross asset and liability positions both increase with uncertainty
• The intuition is simple: the more uncertain the economy is, the larger the need to
hedge against bad outcomes will be, and hedging involves saving in assets that pay
in bad future states and borrowing in assets that pay in good states
 5.5 Summary
• In this class we considered an intertemporal model of the current account with
uncertainty over the future endowment
• We first showed that in a small open economy with incomplete asset markets, an
increase in uncertainty causes an increase in precautionary saving and
improvements in the trade balance and the current account
• This model can potentially explain The Great Moderation where a reduction in
output volatility uncertainty coincided with the beginning of sizable U.S current
account deficits
• The prediction that an increase in uncertainty results in elevated precautionary
saving crucially depends on the assumption that financial markets are incomplete
• Under complete asset markets, households are able to insure against output
volatility without resorting to precautionary saving
• Consequently, the positive relationship between the level of uncertainty and the
current account disappears under complete markets
• When markets are complete, the country’s net international asset position is
independent of the amount of uncertainty in the economy
• But the gross international asset positions are increasing in the level of uncertainty
 Mid-Term Exam

• The exam will be 2 hours

• It will take place in salon 2247
• The exam will consist of 4 questions (25 marks per question)
• The exam will cover the following 4 topics:
❑ Topic 2 – Small 2-period endowment economy model
❑ Topic 3 – Extensions to the endowment economy model (terms of
trade shocks, world interest rate shocks, tariffs)
❑ Topic 4 – Small 2-period production economy model
❑ Topic 5 – Small 2-period endowment economy model with
uncertainty
 Example
Consider a small two-period production economy. Assume the household starts
period 1 with zero asset holdings (i.e., 𝐵0ℎ = 0).
(a) If the period 1 budget constraint is given by:
𝐶1 + 𝐵1ℎ = Π1 𝑟0 , 𝐴1
and the period 2 budget constraint is given by:
𝐶2 + 𝐵2ℎ − 𝐵1ℎ = 𝑟1 𝐵1ℎ + Π2 𝑟1 , 𝐴2
derive the intertemporal budget constraint of the household.

(b) Suppose the economy is initially an equilibrium where the current account is
zero. Discuss what happens to saving, investment, the equilibrium interest rate,
and the current account in response to a temporary increase in productivity 𝐴1 .
Illustrate your answer.

(c) Explain how your answer to part (b) would differ under a closed economy.
Illustrate your answer.

(d) Explain how your answer to part (b) would differ if instead of a temporary
increase in productivity, there was a temporary increase in the terms of trade.