Topic 1
Mann, C.L., 2002, Perspectives on the US Current Account Deficit and Sustainability, Journal
of Economic Perspectives 16 (3), 131-152
A current deficit can mean a country is living beyond its means, where consumption and investment
exceed national savings of the economy, or that the country is an “oasis of prosperity”, attracting
investment from around the globe because its economy delivers higher investment returns at lower
risk.
By the mid-1980s, accumulation of current account deficits and net foreign capital flows turned US
NIIP negative and by end of 2001, NIIP was -$2tn (20% of GDP). Since the late 1970s, the US trade
balance was in deficit and widened dramatically in the mid-1980s when the US economy was growing
strongly relative to the world economy, and narrowed in the early 1990s. Trade deficits/surpluses in
some sectors are characterised by cyclical fluctuations (capital goods and non-energy industrial
supplies) and some display a clear trend (consumer goods and autos).
A current account deficit is “sustainable” if neither it, nor the associated foreign capital inflows, nor the
negative net international investment position are large enough to induce significant changes in
economic variables. A current account deficit can be considered sustainable today but still create
future risks for the US and global economy.
Whether the US current account deficit is sustainable should consider two views:
● Domestic view of US consumption and investment:
○ If financial payments (interest and dividends) from negative NIIP become
so large to cut into current consumption and business investment → deficit
unsustainable.
○ The higher the trend growth rate of the economy, it is easier to service interest and
debt without significantly affecting behaviour of domestic spending. Higher LR growth
allows a country to run a CA deficit for longer. Also consider if foreign capital inflows
have increased productivity growth, then resulting increase in LR GDP enhances an
economy’s capacity to repay.
○ Comes a point when the deficit is too large but difficult to gauge exactly. An economy
running deficits today must start running trade surpluses at some point. If the
accumulation of expected future trade surpluses is too small, principal (NIIP) +
interest cannot be fully repaid and current deficit is too large. If economy is not
required to repay the principal, then CA deficit can continue as long as accumulating
negative NIIP is growing less rapidly than the capacity of economy to service debt.
○ For industrial countries, a CA deficit to GDP ratio of 4-5% seems to be associated
with the onset of economic forces that reduce consumption and particularly
investment to make CA sustainable.
● International financial view of the global investor’s portfolio of wealth:
○ How much global investors are willing to invest in the US economy is a function of
US’ risk-return portfolio, growth of investor’s portfolio of wealth, transaction costs,
information and regulation. Estimating a sustainability benchmark on this is difficult.
○ One approach: consider US net capital inflows relative to global savings. US CA
absorbs about 6% of world savings which is low. Despite globalisation of finance and
financial institutions, market participants put the majority of wealth into domestic
assets.
, ○ Possible benchmark: US CA absorbs about 60% of global aggregated trade surplus
which seems to contradict previous approach and is also likely inaccurate.
Overall, the global investment community seems willing and able to hold sufficient US assets in its
portfolios to finance these deficits for now. Likely that at some point global investors reach a point
where they are no longer willing to increase the share of US assets they hold in and a declining
exchange value of the dollar will force a reduction in CA deficit.
The structural and policy changes that could combine to change the widening trajectory of the current
account deficit include fiscal discipline and more robust household saving in the U.S. economy, more
rapid economic growth abroad underpinned by higher productivity growth, more liberalised domestic
and global markets for services and more deeply integrated euro financial markets. This adjustment
process towards a lower US CA balance is likely to be far smoother vs disruptive sentiment-driven
depreciations in the exchange value of the U.S. dollar.
Topic 4
Chowdhury, I., Sarno L., and M.P. Taylor, 2002, Non-Linear Dynamics in Deviations from the
Law Of One Price: A Broad-Based Empirical Study, CEPR Discussion Paper 3377
Existence of transaction and transport costs and other impediments to trade (tariffs/quotas) likely
cause LOOP to fail. Previous studies suggest that deviations from LOOP should be non-linear if a
consequence of non zero transaction costs and are generally investigated in threshold autoregressive
model (TAR) but are generally based on only a few commodities/currencies. Objective of this study is
to provide broad-based evidence of nonlinearities in deviations from LOOP. Investigate deviations
from LOOP through five major currencies for nine sectors since 1974. Find evidence that in general
TAR model characterises LOOP deviations well.
Deviations from LOOP:
Previous studies find with intra-national trade, deviations from LOOP much lower than for trade across
borders. With non-zero transaction costs, deviations from LOOP will be non-mean reverting as long
as they are smaller than arbitrage costs.
Data comes from OECD, IMF and ISDB databases for the following countries: UK, France, Germany,
Italy, and Japan with the US as reference country.
Results + Conclusion:
● Estimated transaction costs appear to fluctuate widely across countries.
○ Goods markets between US and Japan have lower transaction costs than between
Us and Europe, consistent with previous findings.
○ Adjustment towards LOOP is observed to be fairly fast although delay
parameter is longer than initially expected → LOOP somewhat sticky.
, Engel, C. and J.H. Rogers, 1996, How Wide is the Border? American Economic
Review 86 (5), 1112–1125
Quick Summary
· The authors use CPI data for US and Canadian cities to examine
deviations from the law of one price.
· Find that the distance between cities explains a significant amount of the
differences in prices for similar goods. However, after having controlled for
distance, the difference in prices is much higher for 2 cities in different
countries than for cities in the same country.
· The authors assess reasons for the border effect and find that price
stickiness explains some of it, but most of it is left unexplained.
Intro
· The main aim of this paper is to understand what causes the international
failure of the LOOP, i.e., if there are any other factors than distance
explaining price differentials across countries. The paper mostly assesses
whether price stickiness causes the LOOP to fail, and the impact of
national borders on the failure of the LOOP
· The international failure of the LOOP is a sign that markets are not
perfectly integrated and plays a dominant role in the behaviour of real
exchange rates. It is far more significant in explaining RER movements
than variations in relative prices of different goods within a country’s
borders (i.e., non-traded vs traded goods)
· They use consumer price data split into 14 categories of goods, for 9
Canadian cities and 14 US cities. The hypothesis of the paper is that the
price volatility of similar goods between cities should be positively
correlated to the distance between the cities. However, holding distance
constant, volatility should be higher between two cities separated by the
border.
· The results show that both the distance and the border are significant in
explaining price differentials. They also measure the ‘width’ of the border,
i.e., how important the border is relative to the distance, and find that the
effect of the border relative to the distance is extremely large.
· Potential causes for the border effect include price stickiness, lack of
integration of labour markets and barriers to trade (such as tariffs). While
price stickiness explains some of the border effect, most of it is left
unexplained.
Price Dispersion among locations
