8  Balance of Payments 1

Objectives

  1. Understand concept of (and motivation for) consumption smoothing
  2. Study responeses of open economy to shocks
    1. Temporary
    2. Permanent

8.1 Wealth and Present Value

We first solve the consumption problem. The first condition is the present value condition, which is our equivalent budget constraint condition. Rather than having a constraint between apples and oranges, this constraint is between consumption today (apples today), consumption tomorrow (apples tomorrow), and so on.

Present Value Condition

\[ \begin{align} \text{Present Value of Income} &= \text{Present Value of Wealth} \\ GDP_0 + \frac{GDP_1}{(1+r^*)} + \frac{GDP_2}{(1+r^*)^2} + \cdots &= C_0 + \frac{C_1}{(1+r^*)} + \frac{C_2}{(1+r^*)^2} + \cdots \end{align} \]

The second condition is the consumption smoothing condition. We need it because the present value condition is not enough: it gives a menu of different options but we don’t know which we prefer (will choose).

Consumption Smoothing Condition

For two consumption paths \(C_0, C_1, \dots\) that have the same present value, we prefer the path with constant consumption \(C_0 = C_1 = C_2 = \dots\).

The consumption smoothing condition says that we will choose a flat path of consumption because we dislike variance (ups and downs) in our consumption.. ## Shocks

8.1.1 Temporary Shock

Temporary Shocks

We now consider the responses to a temporary decline in income. In this case, income temporarily declines and then reverts to its original level.

8.1.2 Permanent Shock

Permanent Decline in Income

We now consider the responses to a temporary decline in income. In this case, income permanently declines from its original value. Consumption must again satisfy both the present value and consumption smoothing conditions. As a result, consumption goes down by the same level as income and stays there.

8.2 Conclusion

  • This lecture introduces the concept of consumption smoothing in international finance
  • We show an open economy can more successfully consumption smooth temporary shocks using its trade balance (borrowing/saving)
  • We find that permanent shocks are more damaging in that we cannot ‘consumption smooth’ them