Preface xiii
Chapter 1 Global Imbalances 1
1.1 The Balance of Payments 3
1.2 The Trade Balance and the Current Account 6
1.3 The Trade Balance and the Current Account across Countries 8
1.4 Imbalances in U.S. Trade with China 10
1.5 The Current Account and the Net International Investment Position 12
1.6 Valuation Changes and the Net International Investment Position 13
1.6.1 Examples of Valuation Changes 14
1.6.2 Valuation Changes in the United States 14
1.6.3 A Hypothetical NIIP That Excludes Valuation Changes 17
1.7 The NIIP- Nil Paradox 19
1.7.1 Dark Matter 19
1.7.2 Return Differentials 21
1.7.3 The Flip Side of the NIIP-NII Paradox 22
1.8 Summing Up 23
1.9 Exercises 24
Part I Determinants of the Current Account 31
Chapter 2 Current Account Sustainability 33
2.1 Can a Country Run a Perpetual Trade Balance Deficit? 33
2.2 Can a Country Run a Perpetual Current Account Deficit? 35
2.3 Saving, Investment, and the Current Account 36
2.3.1 The Current Account as the Gap between Saving and Investment 36
2.3.2 The Current Account as the Gap between National Income and Domestic Absorption 38
2.4 Appendix: Perpetual Trade Balance and Current Account Deficits in Infinite Horizon Economies 38
2.5 Summing Up 41
2.6 Exercises 42
Chapter 3 An Intertemporal Theory of the Current Account 44
3.1 The Intertemporal Budget Constraint 45
3.2 The Lifetime Utility Function 47
3.3 The Optima! Intertemporal Allocation of Consumption 50
3.4 The Interest Rate Parity Condition 52
3.5 Equilibrium in the Small Open Economy 53
3.6 The Trade Balance and the Current Account 55
3.7 Adjustment to Temporary and Permanent Output Shocks 56
3.7.1 Adjustment to Temporary Output Shocks 56
3.7.2 Adjustment to Permanent Output Shocks 58
3.8 Anticipated Income Shocks 59
3.9 An Economy with Logarithmic Preferences 61
3.10 Summing Up 62
3.11 Exercises 63
Chapter 4 Terms of Trade, the World Interest Rate, Tariffs, and the Current Account 68
4.1 Terms of Trade Shocks 69
4.2 Terms of Trade Shocks and Imperfect Information 70
4.3 Imperfect Information, the Price of Copper, and the Chilean Current Account 71
4.4 World Interest Rate Shocks 72
4.5 Import Tariffs 75
4.5.1 A Temporary Increase in Import Tariffs 77
4.5.2 A Permanent increase in Import Tariffs 79
4.5.3 An Anticipated Future Increase in Import Tariffs 80
4.6 Summing Up 80
4.7 Exercises 81
Chapter 5 Current Account Determination in a Production Economy 87
5.1 The Investment Decision of Firms 87
5.2 The Investment Schedule 93
5.2.1 The Profit Function 93
5.3 The Consumption-Saving Decision of Households 96
5.3.1 Effect of a Temporary Increase in Productivity on Consumption 98
5.3.2 Effect of an Anticipated Future Productivity Increase on Consumption 99
5.3.3 Effect of an Increase in the Interest Rate on Consumption 101
5.4 The Saving Schedule 102
5.5 The Current Account Schedule 104
5.6 Equilibrium in the Production Economy 106
5.6.1 Adjustment of the Current Account to Changes in the World interest Rate 107
5.6.2 Adjustment of the Current Account to a Temporary Increase in Productivity 108
5.6.3 Adjustment of the Current Account to an Anticipated Future Productivity Increase 109
5.7 Equilibrium in the Production Economy: An Algebraic Approach 110
5.7.1 Adjustment to an Increase in the World Interest Rate 114
5.7.2 Adjustment to a Temporary Increase in Productivity 114
5.7.3 Adjustment to an Anticipated Future Increase in Productivity 115
5.8 The Terms of Trade in the Production Economy 115
5.9 An Application: Giant Oil Discoveries 117
5.10 Summing Up 119
5.11 Exercises 120
Chapter 6 Uncertainty and the Current Account 124
6.1 The Great Moderation 124
6.2 Causes of the Great Moderation 125
6.3 The Great Moderation and the Emergence of Current Account Imbalances 126
6.4 An Open Economy with Uncertainty 126
6.5 Complete Asset Markets and the Current Account 131
6.5.1 State Contingent Claims 131
6.5.2 The Household's Problem 132
6.5.3 Free Capital Mobility 133
6.5.4 Equilibrium in the Complete Asset Market Economy 134
6.6 Summing Up 135
6.7 Exercises 136
Chapter 7 Large Open Economies 141
7.1 A Two-Country Economy 141
7.2 An Investment Surge in the United States 143
7.3 Microfoundations of the Two-Country Model 145
7.4 International Transmission of Country-Specific Shocks 148
7.5 Country Size and the International Transmission Mechanism 149
7.6 Explaining the U.S. Current Account Deficit: The Global Saving Glut Hypothesis 151
7.6.1 Two Competing Hypotheses 151
7.6.2 The Made in the U.S.A. Hypothesis Strikes Back 153
7.7 Summing Up 154
7.8 Exercises 155
Chapter 8 The Twin Deficits: Fiscal Deficits and the Current Account 160
8.1 An Open Economy with a Government Sector 160
8.1.1 The Government 161
8.1.2 Firms 162
8.1.3 Households 163
8.2 Ricardian Equivalence 165
8.3 Government Spending and Twin Deficits 168
8.4 Failure of Ricardian Equivalence: Tax Cuts and Twin Deficits 169
8.4.1 Borrowing Constraints 170
8.4.2 Intergenerational Effects 172
8.4.3 Distortionary Taxation 172
8.5 The Optimality of Twin Deficits 175
8.6 Fiscal Policy in Economies with Imperfect Capital Mobility 178
8.7 Fiscal Policy in a Large Open Economy 181
8.8 Summing Up 183
8.9 Exercises 184
Part II The Real Exchange Rate 191
Chapter 9 The Real Exchange Rate and Purchasing Power Parity 193
9.1 The Law of One Price 193
9.2 Purchasing Power Parity 198
9.3 PPP Exchange Rates 201
9.3.1 Big Mac PPP Exchange Rates 201
9.3.2 PPP Exchange Rates for Baskets of Goods 202
9.3.3 PPP Exchange Rates and Standard of Living Comparisons 202
9.3.4 Rich Countries Are More Expensive Than Poor Countries 205
9.4 Relative Purchasing Power Parity 206
9.4.1 Does Relative PPP Hold in the Long Run? 207
9.4.2 Does Relative PPP Hold in the Short Run? 210
9.5 How Wide Is the Border? 210
9.6 Nontradable Goods and Deviations from Purchasing Power Parity 213
9.7 Trade Barriers and Real Exchange Rates 215
9.8 Home Bias and the Real Exchange Rate 216
9.9 Price Indices and Standards of Living 217
9.9.1 Microfoundations of the Price Level 218
9.9.2 The Price Level, income, and Welfare 220
9.10 Summing Up 221
9.11 Exercises 222
Chapter 10 Determinants of the Real Exchange Rate 227
10.1 The TNT Model 228
10.1.1 Households 228
10.1.2 Equilibrium 231
10.1.3 Adjustment of the Relative Price of Nontradables to Interest Rate and Endowment Shocks 232
10.2 From the Relative Price of Nontradables to the Real Exchange Rate 235
10.3 The Terms of Trade and the Real Exchange Rate 236
10.4 Sudden Stops 238
10.4.1 A Sudden Stop through the Lens of the TNT Model 238
10.4.2 The Argentine Sudden Stop of 2001 240
10.4.3 The Icelandic Sudden Stop of 2008 242
10.5 The TNT Model with Sectoral Production 243
10.5.1 The Production Possibility Frontier 244
10.5.2 The PPF and the Real Exchange Rate 247
10.5.3 The Income Expansion Path 249
10.5.4 Partial Equilibrium 251
10.5.5 General Equilibrium 255
10.5.6 Sudden Stops and Sectoral Reallocations 257
10.6 Productivity Differentials and Real Exchange Rates: The Balassa-Samuelson Model 259
10.7 Summing Up 263
10.8 Exercises 264
Part III International Capital Mobility 273
Chapter 11 International Capital Market Integration 275
11.1 Covered Interest Rate Parity 276
11.2 Covered Interest Rate Differentials in China: 1998-2021 278
11.3 Capital Controls and Interest Rate Differentials: Brazil 2009-2012 279
11.4 Empirical Evidence on Covered Interest Rate Differentials: A Long-Run Perspective 281
11.5 Empirical Evidence on Offshore-Onshore Interest Rate Differentials 283
11.6 Uncovered Interest Rate Parity 285
11.6.1 Asset Pricing in an Open Economy 285
11.6.2 CIP as an Equilibrium Condition 288
11.6.3 Is UIP an Equilibrium Condition? 288
11.6.4 Carry Trade as a Test of UIP 290
11.6.5 The Forward Premium Puzzle 291
11.7 Real Interest Rate Parity 292
11.8 Saving-Investment Correlations 294
11.9 Summing Up 298
11.10 Exercises 299
Chapter 12 Capital Controls 302
12.1 Capital Controls and Interest Rate Differentials 303
12.2 Macroeconomic Effects of Capital Controls 304
12.2.1 Effects of Capital Controls on Consumption, Savings, and the Current Account 304
12.2.2 Effects of Capita] Controls on Investment 308
12.2.3 Welfare Consequences of Capital Controls 309
12.3 Quantitative Restrictions on Capital Flows 309
12.4 Borrowing Externalities and Optimal Capital Controls 311
12.4.1 An Economy with a Debt-Elastic Interest Rate 312
12.4.2 Competitive Equilibrium without Government Intervention 314
12.4.3 The Efficient Allocation 316
12.4.4 Optimal Capital Control Policy 317
12.5 Capital Mobility in a Large Economy 318
12.6 Graphical Analysis of Equilibrium under Free Capital Mobility in a Large Economy 323
12.7 Optimal Capital Controls in a Large Economy 327
12.8 Graphical Analysis of Optimal Capital Controls in a Large Economy 331
12.9 Retaliation 332
12.10 Empirical Evidence on Capital Controls around the World 337
12.11 Summing Up 342
12.12 Exercises 343
Part IV Monetary Policy and Exchange Rates 351
Chapter 13 Nominal Rigidity, Exchange Rate Policy, and Unemployment 353
13.1 The TNT-DNWR Model 354
13.1.1 The Supply Schedule 355
13.1.2 The Demand Schedule 355
13.1.3 The Labor Market Slackness Condition 361
13.1.4 Equilibrium in the TNT-DNWR Model 362
13.2 Adjustment to Shocks with a Fixed Exchange Rate 363
13.2.1 An Increase in the World Interest Rate 364
13.2.2 Asymmetric Adjustment: A Decrease in the World interest Rate 366
13.2.3 Output and Terms of Trade Shocks 368
13.2.4 Volatility and Average Unemployment 370
13.3 Adjustment to Shocks with a Floating Exchange Rate 371
13.3.1 Adjustment to External Shocks 372
13.3.2 Supply Shocks, the Inflation-Unemployment Trade-off, and Stagflation 374
13.4 A Numerical Example: A World Interest Rate Hike 377
13.4.1 The Pre-Shock Equilibrium 378
13.4.2 Adjustment with a Fixed Exchange Rate 379
13.4.3 Adjustment with a Floating Exchange Rate 381
13.4.4 The Welfare Cost of a Currency Peg 381
13.5 The Monetary Policy Trilemma 382
13.6 Exchange Rate Overshooting 384
13.7 Empirical Evidence on Downward Nominal Wage Rigidity 388
13.7.1 Evidence from U.S. Micro Data 388
13.7.2 Evidence from the Great Depression 388
13.7.3 Evidence from Emerging Countries 390
13.8 Appendix 393
13.9 Summing Up 393
13.10 Exercises 394
Chapter 14 Managing Currency Pegs 399
14.1 A Boom-Bust Cycle in the TNT-DNWR Model 399
14.2 The Currency Peg Externality 401
14.3 Managing a Currency Peg 402
14.3.1 Macroprudential Capital Control Policy 403
14.3.2 Fiscal Devaluations 406
14.3.3 Higher Inflation in a Monetary Union 411
14.4 The Boom-Bust Cycle in Peripheral Europe, 2000-2011 415
14.5 Summing Up 417
14.6 Exercises 419
Chapter 15 Inflationary Finance and Balance of Payments Crises 424
15.1 The Quantity Theory of Money 425
15.1.1 A Flexible Exchange Rate Regime 427
15.1.2 A Fixed Exchange Rate Regime 428
15.2 A Monetary Economy with a Government Sector 428
15.2.1 An interest-Elastic Demand for Money 429
15.2.2 Purchasing Power Parity 429
15.2.3 The interest Parity Condition 430
15.2.4 The Government Budget Constraint 430
15.3 Fiscal Deficits and the Sustainability of Currency Pegs 431
15.4 Fiscal Consequences of a Devaluation 432
15.5 A Constant Money Growth Rate Regime 434
15.6 Fiscal Consequences of Money Creation 435
15.6.1 The Inflation Tax 435
15.6.2 The Inflation Tax Laffer Curve 436
15.6.3 Inflationary Finance 436
15.7 Balance of Payments Crises 438
15.8 Appendix: A Dynamic Optimizing Model of the Demand for Money 442
15.9 Summing Up 448
15.10 Exercises 449
Index 457