Chapter 16: International Trade

International Trade

Questions of International Macroeconomics

  • International Trade and the gains from opening up to trade.
  • Sovereign debt and recurrent defaults
  • Flexible vs. fixed exchange rates and capital controls
  • The transmission of macroeconomic shocks among countries.
  • Small Open Economy model is used to analyze current account surplus.
  • Economic agents are price takers.
  • Intertemporal consumption-savings model is used

A Two-Period Small Open Economy

  • Economy lasts for 2 periods → current and future periods.
  • Representative Consumer

Y,YY, Y’– Real income endowment in the current and future periods.

T,TT, T’– Lump-sum taxes in the current and future periods.

C,CC, C’– Consumption in the current and future periods.

  • Can borrow/lend at the world interest rate r, taken as given.
  • Maximizes Utility subject to the lifetime budget constraint:
  • C+C/(1+r)=YT+(YT)/(1+r)C + C’/(1+r) = Y – T + (Y’-T’)/(1+r)

E – Endowment Point

D – The Optimal Point, (C,C)(C*,C’*)

  • Private Savings Sp=YTCS_p = Y – T – C*


G,GG, G’→ Public spending in the current and future periods.

  • Budget Constraint
  • G+G/(1+r)=T+T/1+rG +G’/(1+r) = T + T’/1+r
  • Savings - Sg=TGS_g = T – G

Current Account

  • Current Account Surplus CA is total saving
  • CA=Sp+Sg=YCG=NXCA = S_p + S_g = Y – C* - G = NX
  • Current deficit may allow a country to smooth consumption. If CA=0CA = 0 , C is volatile like Y

Comparative Statics

Effects of Changes in Current Period Income Y

  • If YY ↑  then C,C C*, C’*↑
  • The increase in current period consumption is lower than the increase in income ΔC<ΔYΔC < ΔY , because of consumption smoothing.
  • Net Effect
  • ΔCA>0ΔCA > 0 → The increase in CA surplus results from the country saving more by lending abroad.
  • Data Analysis → Y and CA appear to be uncorrelated in Canada or negatively correlated in the US.
  • Due to business cycles being more severe in the rest of the world.
  • Interest Rates Rise
  • In a recession, Canada is a net exporter (lender).
  • In a boom, Canada is a net importer (borrower)

Effects of Changes in Current Government Spending G

  • If G↑ then consumer’s lifetime wealth reduces as T+T/(1+r)T + T’/(1+r) ↑, causing C,CC*, C’* ↓.
  • ButΔC<ΔG |ΔC| < |ΔG| because of consumption smoothing.
  • Net Effect -
  • ΔCA<0ΔCA < 0 – the decrease in CA surplus results from the country saving less or borrowing more from abroad.

Effects of Changes in Taxes

  • If T↑ then consumer’s lifetime wealth and (C,C)(C*,C’*) do not change because G and G’ remain unchanged and the government’s budget must be balanced.
  • Net Effect
  • ΔCA=0ΔCA = 0

Effects of Changes in the World Real Interest Rate

  • If r↑, there are different effects for both consumer types
  • Net Lender
  • CC* may rise or fall.
  • If substitution effect dominates, CC* ↓ and ΔCA>0 ΔCA > 0 .
  • Net Borrower
  • CC* ↓ causes ΔCA>0ΔCA > 0
  • Net Effect
  • If income effects are small,ΔCA>0 ΔCA > 0 overall.

Production, Investment, and the Current Account

  • Adapting the Real Intertemporal Model with Investment allows the small open economy framework to include production and investment.
  • Agents in the small open economy face the exogenous world real interest rate r.
  • Goods are traded freely with foreign countries.
  • Demand for goods includes net exports:
  • Y=C+I+G+NXY = C + I + G + NX
  • Output demand curve and output supply curve shift in the same ways as in the real intertemporal model → the difference is that interest rate is exogenous and NX adjusts.


YsY^s : - (Upward sloping) outward supply curve in the (Y,r) space

Y1dY^d_1 – (Downward sloping) output demand curve in the (Y,r) space

rr^* - World real interest rate

Example → Small open economy has a positive current account surplus (NX>0NX > 0 ) and therefore lends.

Comparative Statics

Effects of an Increase in the World Real Interest Rate

  • World Interest Rate Increases from r1tor2r_1 to r_2
  • NX adjusts so that output demand shifts right to intersect output supply at the world real interest rate r*.
  • Current Account Surplus CA and output increase.
  • Investment declines as it depends negatively on r.
  • Consumption may rise (due to Y↑) or fall (because r↑)

  • Business Cycles
  • An increase in world real interest rate may result from a negative temporary TFP shock.
  • This raises output in the small open economy.

Effects of a Temporary Increase in G

  • Output Supply Curve YsY^s shifts right because
  • GG ↑ causes lifetime wealth to ↓, ll ↓,Ns N^s
  • Output demand curve Yd shifts right because the direct effect dominates the indirect effect.
  • GG ↑ causes lifetime wealth to ↓, CC ↓, YdY^d
  • As the increase in G is temporary (effects on lifetime wealth are small), the shift of output supply < shift of output demand.
  • Output increases, but current account decreases.
  • Consumption increases because Y↑ and investment stays constant because r* is constant.

Effects of an Increase in Current TFP

  • Primary Effects
  • Output supply curve:z,Nd,Ys z↑, N^d↑, Y^s shifts to the right.
  • For real interest rate to remain unchanged, the current account surplus CA must increase, shifting the output demand curve to the right.
  • YY↑ , soC C↑ with no effect on l.
  • z,l,z' ↑, l ↑, output demand curve YdY^d shifts right (also because CC ↑ with rising Y)
  • Since neither YsY^s nor interest rate rr^* varies, current account surplus CA adjusts downwards so that output demand curve doesn’t change.
  • Income and consumption do not change.

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