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Effects of budgetary policies in open economies: The role of intertemporal consumption substitution
. Journal
o/‘ International
.\lon
Effects
6, 3-3-383
of Budgetary
Policies
in Open
Economies: The Role of Intertemporal Consumption Substitution SLOBODAS DJAJI~ Drpartmcnt
of Economics, Columbia CTniwrsit_v, JYPIP lbrk., NIV 10027, L-S-4, Quwn’s LTnitlersiLy,Kingston~ Canada K7L 3X6, and Institute for International Economic Studirs, Uniwrsify of‘ Stockholm, S- 106 9 1 Sweden
An economy’s optimal response to temporar!: and anticipated future changes in government spending is examined in the contest of a twocountry model which highlights the role of intertemporal consumption substitution (ICS). Special attention is devoted to the case in which the ta’o countries coordinate their fiscal measures. The qualitative effects of such measures on an economy’s current account, terms oftrade (in a twocommodity world), and real exchange and interest rates (in a world aith non-traded goods) are shown to depend on the relationship between the domestic and the foreign elasticities of ICS.
The mechanism
by which
fiscal policy
disturbances
are transmitted
internationally
has been studied extensively over the last few years. The analysis has been conducted within the framework of a new class of open-economy macro models which correctly emphasize the importance of espectations and intertemporal budget constraints. In the context of these models, considerable attention has been devoted to the role of asymmetries between countries in determining the effects of fiscal changes in one economy on the world rate of interest and international capital flows.’ However, the implications of asymmetries in terms of one parameter -the elasticity of intertemporal consumption substitution -which plays an absolutely crucial role in any model of intertemporal trade have not been adequately addressed in the literature.2 If output is exogenously given through time, any change in the time profile of one agent’s consumption must be accompanied by an equal and opposite shift in the aggregate absorption pattern of all other economic agents. In a world economy characterized by free markets, this opposite shift is induced by movements in the real rates of interest, or the relative prices of present goods in terms of goods available for consumption at various dates in the future. For any given change in * This paper was Stockholm. I would Humanities Research Jeremy Greenwood, conversations on the the remaining errors
written while I was visiting the Institute for International Economic Studies in like to thank the Institute for generous hospitality and the Social Sciences and Council of Canada for financial support. I am also grateful to \*ictor Argy, Thorvaldur Gylfason, Gregory Mankiw, and Torsten Persson for useful subject of this paper and two anonymous referees for helpful comments. Any of are, of course, mine.
OX-5606/87/03/03’3-llSO3.00
0
1987 Butterworth
& Co (Publishers)
Ltd
R~I(yrt~lry l’nlirirr in Oiprn Eznnornrrs
3-4 the time adjustment
protile in the
of government rates of interest
spending, the magnitude of the necessarl depends on preferences of agents, particularI>
their willingness to substitute consumption another. This willingness is measured consumption substitution (ICS). To the extent in some in
others.
The
is more
What
adjustment is studied
of ICS
that the elasticity
economies
do
responsive
such
basic
model
is presented
ICS to d(/f>r_fiom
relationship
ntzi(y and
bet\veen
of the flow
such disturbances elasticity of ICS Section scenarios
countries,
household
with
respect
to
I. It is a simplified
two-period,
determined is distinct
terms
of trade
in terms
trade),
capacity
available
of temporary and anticipated spending. Section III studies of policies. It highlights the
to absorb
for private
some extensions of (1) a world in which
disturbances
consumption important
and
role
to the
are shown
time
the effects
of the
the basic model. Three the supply of consumption
of
economl-‘s alternatil-e goods is
in each period, (2) a world in which the output of the from that of the foreign country, and (3) a world in which
is devoted to the case abroad. The qualitative
(in a two-commodity
of non-traded
foreign elasticities Finally, Section
one-
coutltries.3
interest-rate effects foreign government of the same set
on its current account. The is the focus of our analysis.
traded
ir is
spending at home and abroad? This problem model ofa fully-integrated world economv.
to di_l;rrr htwrrrr
an economy’s
special attention both at home and
economy’s
than
international
each economy produces a traded and a non-traded consumption good. growing interest in the implications of international coordination measures, pursued
at
saving
in the real rate of interest
imply
in Section
of goods
IV discusses are considered:
endogenously home country
across
for consumption of intertemporal
of that developed by Frenkel and Razin (1985). ;\t the same more general version in the sense that it allows the elasticity of
Section II examines the real future changes in domestic and the current-account implications profile
differs
to changes
asymmetries
to changes in government below Lvithin a two-country
commodity version time it is a somewhat
at one point in time by the elasticity
to depend
goods on
of ICS. \’ concludes
t!~o/d_r, the recent experience of the an improvement in the terms of terms of non-traded goods) may economy with a relatively low
the the
(when
relationship paper
in which identical policies are effects of such policies on an
world), some
Given the of fiscal
goods
and on its relative do not enter
between
by arguing
that
the
price
of
international
domestic
and
the
if Ricardidu eqwi~~alrm
US economy (including a current-account deficit, trade, and a fall in the relative price of traded in be interpreted to reflect the optimal response of an elasticity of ICS to a common policy shock: a
temporary increase in government spending both at home and abroad. This interpretation of the recent experience should be viewed as complementary to the more conventional one which rests on the presumption that the major policy shifts over the last few years have been specitic to the US economy. To the extent that countries differ in terms of preferences as well as policies, both interpretations contribute to our understanding of the international adjustment mechanism.
I. The Model Let us suppose country, each
that the world economy is made up of a home country and a foreign consisting of a representative household and a government. Time is
SLOBOD.IS DJ.IJI~
3-j
divided into two periods. In each period I (t= 1,2), the home country produces a given quantity .Y. of a single perishable consumption good; the foreign economy Out ofthese quantities, G, and G:% units produces SF units ofthe same commodity. are collected at home and abroad in the form of lump-sum tases and consumed b\ ’ The remaining output is shared by the households ofthe the nation’s government. two countries through fully-integrated international markets for both commodities and bonds. In order to highlight the role of intertemporal consumption substitution, let us assume that residents of the two economies have tastes which are time separable and are identical in all respects escept for the degree of concavity of the utility function. In particular, let us define the level of welfare of the representative household at home and abroad by
(2)
u*(c,*,
c*)
=
c:’ -I’* 1
_o*
+
DC*‘-0’ 7
1-e*
’
in period f respectively. In (1) and (2>, C, and C,* denote household consumption at home and abroad. D is the subjective discount factor (i.e., DE l/(1 +zj), u-here b it is assumed that 6 is identical across is the constant rate of time preference; countries), and the positive constants 0 and o* measure the degree of concavity of the utility function of domestic and foreign residents, respectively. In the event that 0 =o* = 1, the utility functions (l>-<2> take the logarithmic form: L-(. , .) = budget constraints confronting domestic and 1 D’-’ log(C,). Th e intertemporal I foreign households are (3)
C, + RC, ,< IF’ - A-, -G,
+ R(S,
- GJ,
and <4>
C: + RC;c d IV* z A-: -G::
+R(.T(;C -CT),
where W and W* are the discounted net income streams of the two households, and R is the interest rate factor, or the relative price of future in terms of present goods (i.e., R = 1 /(l + r ) , w h ere r is the real rate of interest in the world economy). In maximizing subject to <4), residents of the two economies will choose intertemporal patterns of consumption which satisfy <5>
C, /C, = (R/D)”
and
Ci+;CT = (R/D)’
‘I-.
The sensitivity of a household’s intertemporal consumption profile with respect to R is measured by the elasticity of ICS. In (S), this elasticity is shown to be l/O at home and l/e* abroad. Optimization requires that the intertemporal budget constraints (3) and (4> be satisfied with equality. Use of <5> along with these equations enables us to express ((9
c, = m,W,
c:
(7)
c,
Cz* = m,‘W*
where
=m,W,
m, and rn: are the marginal
= m:w*
(and average)
propensities
to consume
out of
Poiikirs in 0p11 Economics
B~u&tt~~
3-6
a-ealth
in period
t at home
m, =
(8)
and
abroad.
(R 0)‘”
=_ (R/D)“” nt’ = R+(R;D)l”-
R+(R/D)‘“’ 1
rnz f
note
if R=D,
that
In equilibrium, demand
m, =LV~=M~=?J~~=~/(~
the world
in each
period.
.\n
analogous
condition
be shown,
analysis
below
L-pon
substituting
neighbourhood
1 G,=G2=G,
commodity
+G,
goods-market
equilibrium is redundanr.j
our
attention
Spending
it is also
useful
to
is equal
to the world
fGT
this condition
on the market
in period
2. It could
Accordingly, for goods
in the
in period
1.
and the World Rate of Interest
of IV’, W”,
N:. and n/T into (IO),
\ve obtain
an
the interest-rate factor. R, to the government spending By taking the total differential of this relationship in the
of the initial
equilibrium
,* G, =G2‘* =G-* , so that
rnr E t7-1~ 1 ,i(l + R)),
reference,
that focus
*
I
= /n,[Y+nf:IK’*
the definitiok
which relates G, and G:.
future
defines
however, we shall
R+(R/D)“”
+R).
of the single
in period
+s:
II. Government
equation parameters
supply
Thus, s,
(10)
easily
-
n/, + Rm2 = 1 and nrj+ + R~I* = 1. For
Clearly,
1
nr2* =
R+(R;D)“”
’
(defined by S, = S. z ‘y’;‘,ST = .Y,X E -TX. initially D =R and hence n/, =IN? =m: =
we obtain
(11)
Thus, as one would espect to find in a fully-integrated world economy by the initial conditions stated above), a given increase in period-l government the change dG, =AG2 permanent
spending
lowers
(raises)
R by the same
amount
regardless
(described (period-3) of whether
in public expenditure occurs at home or abroad. Aloreover. by setting one obtains the xvell-known result that and nG,*=nGf in (ll>, changes in G and G* have no effect on the world rate of interest.6 On11 future changes changes (L!G, # 0, nG7 # 0, nG, =dG? =O) or anticipated
temporary (nG, =dGT =O, dG2 # 0, nG* # 0) affect the relative price of present in terms future goods.’ Equation (11) also shows that the proportional decline in R following temporary increase in government spending is equal to the ratio of that increase sum of current private spending (/,1W’;o) +(/iilY’*/6*). Th e 1atter is a weighted being the domestic and the foreign Thus, the greater the values of l/e of the households’ interremporal
of a to at
home and abroad, ICS, 110 and l/o*, hence the greater
the weights respectively. the sensitivity
profiles
to changes
in R) the smaller
price
of
present present
in terms of future goods in response to any given shift in the supply goods available for private consumption. Similarly, in the case ot
of an
the necessary
adjustment
elasticities of and 1 ox (and consumption
in the relative
377
DJ.+JI~:
SLOBODAS
increase in the level of anticipated&tire government spending, the increasr in R is again inversely related to 1 /ti and l/e*. III. Current-Account The home country’s between its income
current-account and absorption.
(1.2)
of
Implications
surplus
S = X, -m,
the magnitude
in period
1 is given
by the difference
W-G,.
As shown in <3) and (8>, both Wand m, are functions of R. After substituting these relationships into (12>, differentiating the resulting espression, and using the between J solution for dR provided by (1 l>, we obtain the following relationship and government spending at home and abroad. (13)
dS = -(l +(l
-k)(l -+dG:
-a)dG, -(l
+(l
-1;;)(1
-a)dG,
-ii)adG:,
where 0 defines the size of the home country (relative to the world terms of its ability to absorb disturbances to the supply of goods private consumption. That is <14)
IV*iO*
W/B d = (w/e)+(w*/o*)’
economy) in available for
1 -g
= ([rye) +(IIyO*)’
In this sense, the size of a country is measured by the pro~r/rf of total expenditure (wealth) of the private sector and the elasticity of ICS. the greater its capacity to absorb disturbances, The larger the economy, regardless of whether they originate at home or abroad. Accordingly, in equation (13>, as we consider increasingly higher values of G in the interval from zero to unity, the current-account effect of any given change in government spending at home declines in absolute value from a maximum oi(1 -ri)dG, units of output to a minimum of zero. The same equation reveals that the current-account effect of a shift in foreign spending growr with 0 from a minimum of zero to a masimum of (1 -fi)dG,* units of output. In order to gain some intuition behind this result, let us consider the effects of a temporary increase in government spending at home (dG, > 0). At the original rate of interest, the policy creates an excess demand for present goods equal to dG, -%dG, units of output. The second, negative term reflects the fall in private consumption as households realize that a lump sum tax of dG, units of output accompanies the rise in government spending. Clearly, if the home country is ‘small’ (as measured by o), the policy has only a negligible effect on the world rate of interest. In the limit, as cr + 0, the economy’s excess demand for present goods of (1 -&)dG, units is satisfied through a current-account deficit of the same magnitude. At the other extreme is the case in which the home country is so large that it constitutes the world economy itself (i.e., d = 1). The same temporary increase in government spending now raises the rate of interest to the extent necessary to eliminate internal4 the excess demand for present goods generated by the policy, while the current account remains continuously balanced. In general, the greater the value ofa, the more of any given domestic disturbance
33
Ric(yrtd~y Policies in Open Eionomiri
is absorbed internally and the less of it is ‘esported’ to the foreign country through the current account. ;in application of this same argument from the perspective of the f&-r~~n country can be used to explain the relationship bet\veen G and the current-account implications of fiscal disturbances originating ni~ra&. In terms of the sign of the current-account effect associated with a gil-en policy, (13) reveals that an increase in either G, or G$ gives rise to a period-l deficit for the home country, while an increase in Gy or G2 gives rise to a surplus. These results confirm the popular notion that in order to eliminate the current-account deficit of the L’S economy, there must be either a cut in current government spending in the USA or an expansion in the rest of the world. However, at a more subtle level, the results also reveal that perfect synchronization of fiscal polic) measures across countries may not succeed in preserving current-account balance. In demonstrating this, let us consider the current-account implications of a fullycoordinated temporary increase in government spending. To simplifv the analysis, let us assume that government spending is initially the same fracticjn of GNP in each economy and identical across periods. A coordinated temporary fiscal expansion can then be defined as C/G, ;S=C%: S*> 0, and nG2 =nG* =O. 0) introducing these relationships into (13), we observe that the effect of the police on the current account of the home country is given by
where use was made of the fact that IK’*i_~* =Il~.;_~.8 The espression in (15) is equal to zero only if the elasticities of ICS are the same in the txvo economies. However, if 110 # l$*, the internationally coordinated temporary increase in government spending entails a surplus (deficit) on the current account of the economy with the relatively higher (lower) elasticity of ICS. The intuition behind this result is simple to grasp. We know that a coordinated temporary increase in government spending at home and abroad generates an escess demand for present goods and an escess supply of future goods. This eserts upward pressure on the world rate of interest. ‘-1s r rises to restore equilibrium, the economv with the more elastic intertemporal pattern of consumption eshibits a relatively sharper cut in current private spending. Accordingly, in the new equilibrium with a higher r, this same economy will have a current-account surplus. It can also be shown that the announcement ofa similarly coordinated increase in _/ktzu-c government spending gives rise to a deficit (surplus) on the current account of the economy with the relatively higher (lower) elasticity of ICS. In this case it is the fall in r which stimulates present consumption to a greater estent in the . economy with the relatively more elastic intertemporal spending pattern, resulting in a current-account deficit. IV. Further
Extensions
This section considers three extensions of the basic model. First, it introduces the possibility of trading present for future consumption by means of investing in physical capital. Second, it draws a distinction between domestic and foreign goods, enabling us to study the effects of changes in government spending on the terms of trade. Finally, it extends the basic model by introducing non-traded goods into the analysis.
SLOBOD.+X DJ.IJI~
3-9
1 I T_-I. Intrrtrmporal Production Shtitrrtion
The assumption that output is exogenous in each period may be relaxed in favor of a more general specification of the supply side. For example, if the possibility of investment offers the economy an opportunity to increase the supply (S,) of goods available for household and government consumption in the second period at the espense of that available in the first period (S,), u-e may define the intertemporal transformation functions of the two economies b! (16)
A-> = _f(.Y, ),
SF
= f‘“(‘YI*)
decreasing and strictly concave.g In the event wheref‘( .) andf*( .) are continuous, that production technologv or the institutional framework governing investment decisions is not the same in’the two countries, the elasticity of f‘( .) may differ from that ofJ*( e) in the neighborhood of the initial equilibrium (Ix., the point on f‘( .) 1 and on f‘*( .) at which f“( .) =_/‘*‘( *) = -l/R). \‘‘aturally, the economv with the relatively more elastic intertemporal transformation function exhibits a relatively greater supply response to changes in the world rate of interest in the same nay that the economy with the relatively larger elasticity of ICS exhibits a relatively greater Since the current account reflects the gap between the demand response. economy’s supply and demand for goods in a given period, the current-account implications of being the economy with the relatively higher elasticity of ICS are with the relatively more elastic very similar to those of being the economy intertemporal transformation function. In illustrating this point. let us consider a situation in which the world rate of interest is pushed up due to a (coordinated) temporary increase in go\-ernment expenditure both at home and abroad. Let us assume further that the two economies differ only in terms of the elasticities of their intertemporal transformation schedules. Since the economy with the higher elasticity exhibits a relatively largerdrcline ininrrstmmtztspending in response to the increase in I-, it enjoys a current-account surplus.
I1 /.B. Two-Commodity World
Another way of generalizing the model of Section I is by drawing a distinction between the domestic and the foreign goods. This distinction introduces an important variable into the analysis: the relative price of domestic in terms of foreign goods or the commodity terms of trade. To get some flavor of the importance of the elasticity of ICS in this more general setting, let us consider the simplest possible two-commodity extension of our model. In particular, let the consumption index C, in equation take the form, (17)
C, = H;F;-‘,
O
where r is the (constant) share of domestically produced good (H), and 1 -x is that of the foreign good (F) in total expenditure of domestic residents. The foreign consumption index CF is similarly defined, with an asterisk signifying foreign variables. In order to highlight the role of intertemporal consumption substitution in the relationship between public expenditure and the terms of trade, let us suppose:
_%I,
BdKcfay
Policies in Oprn Economies
(a) that the HF composition of government spending in each economy is identical to that of the economy’s household spending, (b) that government spending is initially the same fraction of GNP in each economv and identical across periods, and (c) that fiscal measures are internationally coordinated in the sense that an increase in government spending at home in p&iod t is accompanied by an identical increase (as a percentage of GNP) abroad. A temporary increase in government spending of this type lowers the relative price of domest.ic in terms of foreign goods in the economy with the relatively higher elasticity of ICS, provided the espenditure share of domestically-produced goods is larger at home than it is abroad.‘” What is the intuition behind this result? On the basis ofthe discussion in Section III, it should be clear that the country with the relatively higher elasticity of ICS develops a current-account surplus in response to a coordinated temporary fiscal espansion while the other economy develops a corresponding deficit. Thus, in the former economy, espenditurc (private plus public) fblls relative to income in the first period while it increases in the latter economv. If residents of each countr! have a relatively stronger preference for the locally-produced good, at the original terms of trade there emerges an excess supply in the first period of the good produced in the country with the higher elasticity of ICS and an escess demand for the good produced by the other country. In order to restore equilibrium, the relative price of the good produced in the economy with the higher elasticity of ICS must fall in period 1. An analogous argument can be used to show thar the relative price of this same economy’s good must rise in period 2. If a similarly coordinatedfr,tctrr increase in government spending is .lnnounced, the terms-of-trade effects are esactly the opposite. For the economlwith the relatively higher elasticitv of ICS, the current (future) terms of trade improve (deteriorate).
I I ‘.C. Lh’on-Tradd
Goods
Finally, let us consider the version of our model in which H, in equation (17) is interpreted to be the rate of consumption of an internationally non-traded good and F, as the rate of consumption of a single traded commodity. In order to focus once again on the role of intertemporal consumption substitution, let us suppose that, in addition to assumptions (a) and (b) of the previous subsection, a concave, timeinvariant production-possibilities frontier relates the output of traded to that of non-traded goods in each economy. It can then be shown that an internationallycoordinated (in the above sense) temporary increase in government spending raises the current and lowers the future relative price of traded in terms of non-traded goods in the economy with the higher elasticity of ICS. Because the economy with the higher elasticity is the one in which expenditure falls relative to income in period 1 and rises relative to income in period 2, the relative price of traded in terms of non-traded goods must increase in this economy in the first period and fall in the second period. I1 Of course, the opposite relative price changes occur in the economy with the relatively lower elasticity of ICS. There are important implications of these opposing relative-price movements: on the supply side, shifts in the allocation of productive resources between traded and non-traded sectors are in one direction at home and in the opposite direction abroad. In addition, because the relative price of traded in terms of non-traded
SLOBOD.W T.IBLE I. Government
Cnited States European Four major countriesb Total OECD itw the United States
tinal
381
DJ.IJI~
consumption
as percentage
of GDP.”
1978
19-9
1981)
1981
1982
1083
1981
I?.7
l-.6
18.3
18.2
19.2
19.3
18.8
17.8
l-.8
18-l
19.2
19.3
19.4
19.-I
15.8
15.9
16.5
16.7
16.9
16.8
16.5
’ Government tinal consumption expenditure mainI!- consists of current purchases of goods and services for public administration, defence, health and education. It excludes all transfer payments. b Germany, France. United Kingdom and Italy. Soan~ q‘n’uf~: Table RG. OECD, EMMWM~L 011/o&, December 1985.
goods falls (rises) between periods 1 and 2 in the economy with the higher (lower) elasticity of ICS, its consumers face a real rate of interest -stated in terms of the representative household’s consumption basket -which is lower (higher) than the real rate of interest measured in terms of traded go0ds.l” Thus, following a coordinated temporary increase in government spending, one should expect to observe that the consumption-based real rate of interest is lower in the economy with a current-account surplus than it is in the economy with a deficit. V. Concluding
Remarks
Some previous studies have attempted to esplain current-account fluctuations on the basis of models which highlight distinctions between domestic and foreign fiscal measures. While tax policies of countries have deviated very signiticantly from one another over the last few years, the data presented in Table 1 seem to indicate that changes in the time profile of government consumption have been quite similar. To the extent that these expenditure changes are espected to remain in effect for the same period of time, and to the esteut that Ricardian eqhalem-e holds, some of the recent developments may reflect asymmetric reactions of countries to a common set of policies rather than adjustment to policies implemented in just one of the countries. In pursuing this line of investigation, we have found that the experience of the USA over the last few years (including a current-account deficit, an improvement in the terms of trade, a fall in the relative price of traded in terms of non-traded goods, and an increase in the consumption-based real rate of interest relative to the traded-goods rate) is qualitatively similar to that of an economy with a relatively low elasticity of ICS responding to a temporary increase in government spending both at home and abroad.
Notes 1. See, e.g., hizenman (1983), Buiter (1986). Djajii (1985). Frenkel and Razin (1985, 1986a, 1986b), Greenwood and Kimbrough (1983). Persson (1983), and van K’ijnbergen (1985). The recent paper by Marion and Svensson (1986) is of related interest. 2. In the context of small-country models, the importance of this elasticity is illustrated by Dornbusch (1983), Obstfeld (1983, 198j), and Djajic (1986). among others. Giovannini (1984) distinguishes between domestic and foreign elasticities in the context of a two-country, uncertainlifetime model of capital accumulation.
3 Several ‘Ittempts have been made to estimate the value of this elnsticlty on the basis of L‘S data: Hall (1981) has reported a value ofabout I 15, Alankiw : 1051)ofabout I 4. Hansen and Singleton (1982) in the range betueen I and 1.5, and ,\l.lnkiu rt ‘ii. j 1985)h.lvr rrpc~rtedvaluesanthe range bet\veen I and II). The contlicting nature of these iindlnps retlects the very serious estimation problems lvhlch exist, as \vell as the problems of m<.lsuring consumption, expected lifetime income, rates of return, and other key variables. I am nor a\vare of any multi-country studies of this tvpr, other than the one by Giorannini (198-l) \vhich reports ver)- lo\v estimates of the rlasti&r of ICS for a number of LDCs. One should note, ho\vever. th.lt problems \vith LDC data are even more serious than those uith the YS data. The assumption that the public-sector budget is balanced in each period is made without any loss of generality. In a world such as the one analpsed here, a s\ritch from lump-sum-tax to debt finance has no effect on the economy’s current accc~nt nor on any of the variables interest in the remainder ofthe paper. For further discussion ofthis ‘Ricardinn equivalence’ protwsition, see Bnrro (10-4). by using equation ( II)). the detinttl,lns of W’and II..* in (3) and (4). and the 3. It can be obtained fact that ,,I, + KN+ = I. if\ve relaxed the assumption that ci is independent ofthe level 6. There Lvould be an effect, ofcourse, ofwelfareenioyed by the household. On this, see Obstfeld (1982) and S\-ensson and Rnzin (198.3). There is also an interesting issue of uhether one should assume th.lt agents are able to insure themselves against unforeseen changes in tiscal policy-. To the extent that agents participate in such insurance markets, some of the conclusions of the present paper lvould be affected. For an analysis of this problem, see Stockman (1086). Effects of exogenous changes in output can be esnmlned to confirm the familiar result that dK ‘?f.Y, =dR,‘d,Y: = -&dG, = -dR/dG:. 8. \\‘e kno\v that lI~‘;.~=(l + R)[ 1-~?;.y] and K” ,y* = I + K)[ 1--c- ,y*] \vherc c and c* are the initial rates of government spending in the t\vo economies over the t\vo periods. Since t?*i \vas assumed equal to c* .y* K’,l.y= W’*;,t’*. 9. See, for example, Bruce and Pirvis (1985) and Sachs (1~181) for a more extensit-e analysis of the role of investment in a similar setting. happen to have the relatively stronger preference for the good produced IO. If foreigners in the home county, the reverse is true. of the inverse relationship between an economy’s absorption and II. For a more extensive discuwon its relative price of traded in terms of non-traded goods see, e.g., Dvrnbusch (1983) and Razin (198-y. (1983), r,, the real rate of interest measured in terms of the economy’s 12. As shown by Dornbusch consumption basket (assuming preferences are defined by equations (I) and (I->, nhere Hand F represent consumption of non-traded and traded goods, respectively) is given by r, = (1 +r)(P,iP&‘-I, where r is the world rate of interest measured in terms of traded goods and I-‘, is the relative price of traded in terms of non-tr.aded goods in period t. If I-‘, > I’,, r,< r and U~CPLYT~~Z, as stated in the test. See Devereus (1956) for a more detailed stud!- of a twocountry extension of the Dornbusch (1983) model.
of
References ;\IZESSIAN, JosttCA,
‘A Theory of Current Account and F.xchange Rate Determinations,’ Ewopran Economic Rwiw, December 1983, 23: 261-280. Bonds Set \\‘-ealth?,’ Jomzd of Politiini Eronon~, B.\RRO, ROBERT J., ‘Are Government November!December 1974, 82: 1095-1117. BRCCE, NEIL, ASD Douc~.ts D. PVRVIS, ‘The Specitication and Intluence of Goods and Factor XIarkets in Open-Economy AIacroeconomic Models. ’ in R.\Y. Jones and P.B. Kenen, eds, Korth-Holland Publishing Company, Handbook of International Economics, 1’01 2, Amsterdam: 1985. BLYTER, WILLEM H., ‘Fiscal Policy in Open Interdependent Economies,’ in A. Razin and E. Sadka, eds, Economic Policy in Thor and Practice, London: MacMillan, 1986. DEVEREUS, MICHAEL, ‘Nontraded Goods and the International Transmission of Fiscal Policy,’ unpublished paper, University of Toronto, July 1986.
. .
SLOBOIILX DJ.IJI~:
383
DJ.~J[?, SLOBODV, ‘;\ ,\[odel oi Trdt in Exhaustible Rrsources,’ Queen’s L’niversity, Discussion Paper No. 607, Alay 1985. Forthcoming, In~~rnationul E‘.onomic Rrrirw. DJ.IJI~;,SL~B~O.~S, ‘Temporary Import Quota and the Current .\ccount.’ Queen’s L’mversity, /r,.vr~rr/ o/’ 1~t~r~~/or~u( Ezortl,rr,h~~. Discussion Paper So. 6-l’. .\pril 1986. Forthcoming. DORsBC.jCH, RV~IGER, ‘Real Interest R.nes, Home Goods aid Optimal Escrrn.d Borro~ing,‘jollr,c‘j( of Pohicd Eronoq, February 1083, 91: lA1-153. Spending, Debt, and International Economic FRESKEL, J.ICOB, ASD ASSAF R.4zrz. ‘Government Economic Jo~rn&, September 1985, 95: 6 t 9-636. Interdependence,’ Transmission and Effects of Fiscal FRENEEL, JACOB A., AND ASSAF R.LZIN, ‘The Internation~~l Policies,’ .-imrricon Economic Rn,iw. &[a~ 1986, 76: 33C335 (1986n). FRENKEL, J.~coB, AND ASSAF R.IZIN, ‘Fiscal Poliq in the World Economy,’ Joumnuf 41’ Politirul Economy, June 1986, 94: 56&50-l (1986b). Grov.4r~1sr, ~\LBERI-O,‘The Real Exchange Rate, the Capital Srock, and Fiscal Policy,’ unpublished Columbia L’niversity, October 198-1. Forthcoming, paper, Graduate School of Business, Europran Economic Review. Grov~ss~sr, ALBERTO, ‘Saving and the Real Interest Rate in I.DC,’ lo//l.~ti/~)/-nr~.u/opmr)rf E~xww~~jt.x, 1985, 18: 197-217. GREENWIOD, JEREMY, .4so KEST P. ~;I~IBRO~GH, ‘Capital Controls and Fiscal Policy in the World Economy,’ Can&dn Journal or’ Economics, November IOSj. 18: -4%-05. ~IALL, R~EER~ E., ‘Intertemporal‘substitution in Consumption,’ unpublished p.lper, July 1981. HASSES, L.IKS PETER, .ISD KENSETH SISGLETOS, ‘Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations hlodels,’ Eronometria. September 1982, 50: 1269- 1286. I\IANK;IW, GREGORY N., ‘The Permanent Income Hypothesis and the Real Interest Rate,’ E‘xnomiks Lrtters. 1981, 7: 30-31 1. MA.NKIU', GREGORY S., ‘Inrertemporal JULIO J. ROTEMBERG, .ASD L.~U.RESCE 11. Sl’uMERS, Substitution in Alacroeconomics, p~ulartrr!~ Journal o/‘E‘vnomi‘lr, February 1985, 100: X-25 I. 1\[.4RtoN, N.~SCY PEREGRM, ASD L.4~s E.O. SVE\isOS, ‘The Terms ofTrade between Oil Importers,’ Journal oj,/’lnternation~rl Eronomh. February 1986, 20: 99-l 13. OB~T~-EL~), ,\1.4cRtcfz, ‘;\ggregate Spending and the Terms of Trade: Is There a L.nursen-.\Ietzler Effect?,’ ewrfcrb Jaumul of‘ El.onomics, Alav 1982, 97. . _ ‘5 lP2-0, OBSTFEL~, XIL.RICE, ‘Intertemporal Price Spe&lntion and the Optimal Current ;\ccounr Deficit,’ Jourm~l of‘ IntermztionoI z\long nud Finance, i\ugust 1983. 2: 133%145. OBSTFELD, MACRICE, ‘The Capital Intlows Problem Revisited: .i Stylized &lode1 of Southern Cone Disinflation,’ Reritw of Economic Stlrdies, October 1985, 52: GI!S-625. PERSWS, TORSTEN, ‘Deficits and Intergenerational Welf~~re in Open Economies,’ jwrtral o/’ Intrrna‘iomzl Economics, August 1985, 19: 67-81. RAZIN, &S.IF, ‘Capital Alovemenrs, Intersectoral Resource Shifts and the Trade Balance.‘ E.woptwn Economic Rrr~iew, 1983, 26: 135-152. SACHS, JEFFREY, ‘The Current Account and Economic Adjustment in the 19:Os, Rmokiq~ P~pprrs on Economic .-tcthig, 1981, 201-268. STOCKMAN, .IL.IS C., ‘Fiscal Policies and International Financial Alarkets,’ Rochester Center for Economic Research, University of Rochester, Working Paper No. 36, January 19SG. SVENSSOS, L.4RS E.O., AS" hsS.iF R.~zIs, ‘The Terms of Trade and the Current Account: The Harberger-Laursen-Aletzler Effect,’ Journal o/‘Po/iticu/ Erouomy, February 1983, 91: 9’-125. v.4~ WIJSBERGEX, SLVEDER, ‘On Fiscal Deticits, ;he Real Exchange Rate and the \Yorld Rate of Interest,’ Center for Economic Policy Research, Discussion Paper No. 21, July 19%.
o/‘ International
.\lon
Effects
6, 3-3-383
of Budgetary
Policies
in Open
Economies: The Role of Intertemporal Consumption Substitution SLOBODAS DJAJI~ Drpartmcnt
of Economics, Columbia CTniwrsit_v, JYPIP lbrk., NIV 10027, L-S-4, Quwn’s LTnitlersiLy,Kingston~ Canada K7L 3X6, and Institute for International Economic Studirs, Uniwrsify of‘ Stockholm, S- 106 9 1 Sweden
An economy’s optimal response to temporar!: and anticipated future changes in government spending is examined in the contest of a twocountry model which highlights the role of intertemporal consumption substitution (ICS). Special attention is devoted to the case in which the ta’o countries coordinate their fiscal measures. The qualitative effects of such measures on an economy’s current account, terms oftrade (in a twocommodity world), and real exchange and interest rates (in a world aith non-traded goods) are shown to depend on the relationship between the domestic and the foreign elasticities of ICS.
The mechanism
by which
fiscal policy
disturbances
are transmitted
internationally
has been studied extensively over the last few years. The analysis has been conducted within the framework of a new class of open-economy macro models which correctly emphasize the importance of espectations and intertemporal budget constraints. In the context of these models, considerable attention has been devoted to the role of asymmetries between countries in determining the effects of fiscal changes in one economy on the world rate of interest and international capital flows.’ However, the implications of asymmetries in terms of one parameter -the elasticity of intertemporal consumption substitution -which plays an absolutely crucial role in any model of intertemporal trade have not been adequately addressed in the literature.2 If output is exogenously given through time, any change in the time profile of one agent’s consumption must be accompanied by an equal and opposite shift in the aggregate absorption pattern of all other economic agents. In a world economy characterized by free markets, this opposite shift is induced by movements in the real rates of interest, or the relative prices of present goods in terms of goods available for consumption at various dates in the future. For any given change in * This paper was Stockholm. I would Humanities Research Jeremy Greenwood, conversations on the the remaining errors
written while I was visiting the Institute for International Economic Studies in like to thank the Institute for generous hospitality and the Social Sciences and Council of Canada for financial support. I am also grateful to \*ictor Argy, Thorvaldur Gylfason, Gregory Mankiw, and Torsten Persson for useful subject of this paper and two anonymous referees for helpful comments. Any of are, of course, mine.
OX-5606/87/03/03’3-llSO3.00
0
1987 Butterworth
& Co (Publishers)
Ltd
R~I(yrt~lry l’nlirirr in Oiprn Eznnornrrs
3-4 the time adjustment
protile in the
of government rates of interest
spending, the magnitude of the necessarl depends on preferences of agents, particularI>
their willingness to substitute consumption another. This willingness is measured consumption substitution (ICS). To the extent in some in
others.
The
is more
What
adjustment is studied
of ICS
that the elasticity
economies
do
responsive
such
basic
model
is presented
ICS to d(/f>r_fiom
relationship
ntzi(y and
bet\veen
of the flow
such disturbances elasticity of ICS Section scenarios
countries,
household
with
respect
to
I. It is a simplified
two-period,
determined is distinct
terms
of trade
in terms
trade),
capacity
available
of temporary and anticipated spending. Section III studies of policies. It highlights the
to absorb
for private
some extensions of (1) a world in which
disturbances
consumption important
and
role
to the
are shown
time
the effects
of the
the basic model. Three the supply of consumption
of
economl-‘s alternatil-e goods is
in each period, (2) a world in which the output of the from that of the foreign country, and (3) a world in which
is devoted to the case abroad. The qualitative
(in a two-commodity
of non-traded
foreign elasticities Finally, Section
one-
coutltries.3
interest-rate effects foreign government of the same set
on its current account. The is the focus of our analysis.
traded
ir is
spending at home and abroad? This problem model ofa fully-integrated world economv.
to di_l;rrr htwrrrr
an economy’s
special attention both at home and
economy’s
than
international
each economy produces a traded and a non-traded consumption good. growing interest in the implications of international coordination measures, pursued
at
saving
in the real rate of interest
imply
in Section
of goods
IV discusses are considered:
endogenously home country
across
for consumption of intertemporal
of that developed by Frenkel and Razin (1985). ;\t the same more general version in the sense that it allows the elasticity of
Section II examines the real future changes in domestic and the current-account implications profile
differs
to changes
asymmetries
to changes in government below Lvithin a two-country
commodity version time it is a somewhat
at one point in time by the elasticity
to depend
goods on
of ICS. \’ concludes
t!~o/d_r, the recent experience of the an improvement in the terms of terms of non-traded goods) may economy with a relatively low
the the
(when
relationship paper
in which identical policies are effects of such policies on an
world), some
Given the of fiscal
goods
and on its relative do not enter
between
by arguing
that
the
price
of
international
domestic
and
the
if Ricardidu eqwi~~alrm
US economy (including a current-account deficit, trade, and a fall in the relative price of traded in be interpreted to reflect the optimal response of an elasticity of ICS to a common policy shock: a
temporary increase in government spending both at home and abroad. This interpretation of the recent experience should be viewed as complementary to the more conventional one which rests on the presumption that the major policy shifts over the last few years have been specitic to the US economy. To the extent that countries differ in terms of preferences as well as policies, both interpretations contribute to our understanding of the international adjustment mechanism.
I. The Model Let us suppose country, each
that the world economy is made up of a home country and a foreign consisting of a representative household and a government. Time is
SLOBOD.IS DJ.IJI~
3-j
divided into two periods. In each period I (t= 1,2), the home country produces a given quantity .Y. of a single perishable consumption good; the foreign economy Out ofthese quantities, G, and G:% units produces SF units ofthe same commodity. are collected at home and abroad in the form of lump-sum tases and consumed b\ ’ The remaining output is shared by the households ofthe the nation’s government. two countries through fully-integrated international markets for both commodities and bonds. In order to highlight the role of intertemporal consumption substitution, let us assume that residents of the two economies have tastes which are time separable and are identical in all respects escept for the degree of concavity of the utility function. In particular, let us define the level of welfare of the representative household at home and abroad by
(2)
u*(c,*,
c*)
=
c:’ -I’* 1
_o*
+
DC*‘-0’ 7
1-e*
’
in period f respectively. In (1) and (2>, C, and C,* denote household consumption at home and abroad. D is the subjective discount factor (i.e., DE l/(1 +zj), u-here b it is assumed that 6 is identical across is the constant rate of time preference; countries), and the positive constants 0 and o* measure the degree of concavity of the utility function of domestic and foreign residents, respectively. In the event that 0 =o* = 1, the utility functions (l>-<2> take the logarithmic form: L-(. , .) = budget constraints confronting domestic and 1 D’-’ log(C,). Th e intertemporal I foreign households are (3)
C, + RC, ,< IF’ - A-, -G,
+ R(S,
- GJ,
and <4>
C: + RC;c d IV* z A-: -G::
+R(.T(;C -CT),
where W and W* are the discounted net income streams of the two households, and R is the interest rate factor, or the relative price of future in terms of present goods (i.e., R = 1 /(l + r ) , w h ere r is the real rate of interest in the world economy). In maximizing
C, /C, = (R/D)”
and
Ci+;CT = (R/D)’
‘I-.
The sensitivity of a household’s intertemporal consumption profile with respect to R is measured by the elasticity of ICS. In (S), this elasticity is shown to be l/O at home and l/e* abroad. Optimization requires that the intertemporal budget constraints (3) and (4> be satisfied with equality. Use of <5> along with these equations enables us to express ((9
c, = m,W,
c:
(7)
c,
Cz* = m,‘W*
where
=m,W,
m, and rn: are the marginal
= m:w*
(and average)
propensities
to consume
out of
Poiikirs in 0p11 Economics
B~u&tt~~
3-6
a-ealth
in period
t at home
m, =
(8)
and
abroad.
(R 0)‘”
=_ (R/D)“” nt’ = R+(R;D)l”-
R+(R/D)‘“’ 1
rnz f
note
if R=D,
that
In equilibrium, demand
m, =LV~=M~=?J~~=~/(~
the world
in each
period.
.\n
analogous
condition
be shown,
analysis
below
L-pon
substituting
neighbourhood
1 G,=G2=G,
commodity
+G,
goods-market
equilibrium is redundanr.j
our
attention
Spending
it is also
useful
to
is equal
to the world
fGT
this condition
on the market
in period
2. It could
Accordingly, for goods
in the
in period
1.
and the World Rate of Interest
of IV’, W”,
N:. and n/T into (IO),
\ve obtain
an
the interest-rate factor. R, to the government spending By taking the total differential of this relationship in the
of the initial
equilibrium
,* G, =G2‘* =G-* , so that
rnr E t7-1~ 1 ,i(l + R)),
reference,
that focus
*
I
= /n,[Y+nf:IK’*
the definitiok
which relates G, and G:.
future
defines
however, we shall
R+(R/D)“”
+R).
of the single
in period
+s:
II. Government
equation parameters
supply
Thus, s,
(10)
easily
-
n/, + Rm2 = 1 and nrj+ + R~I* = 1. For
Clearly,
1
nr2* =
R+(R;D)“”
’
(defined by S, = S. z ‘y’;‘,ST = .Y,X E -TX. initially D =R and hence n/, =IN? =m: =
we obtain
(11)
Thus, as one would espect to find in a fully-integrated world economy by the initial conditions stated above), a given increase in period-l government the change dG, =AG2 permanent
spending
lowers
(raises)
R by the same
amount
regardless
(described (period-3) of whether
in public expenditure occurs at home or abroad. Aloreover. by setting one obtains the xvell-known result that and nG,*=nGf in (ll>, changes in G and G* have no effect on the world rate of interest.6 On11 future changes changes (L!G, # 0, nG7 # 0, nG, =dG? =O) or anticipated
temporary (nG, =dGT =O, dG2 # 0, nG* # 0) affect the relative price of present in terms future goods.’ Equation (11) also shows that the proportional decline in R following temporary increase in government spending is equal to the ratio of that increase sum of current private spending (/,1W’;o) +(/iilY’*/6*). Th e 1atter is a weighted being the domestic and the foreign Thus, the greater the values of l/e of the households’ interremporal
of a to at
home and abroad, ICS, 110 and l/o*, hence the greater
the weights respectively. the sensitivity
profiles
to changes
in R) the smaller
price
of
present present
in terms of future goods in response to any given shift in the supply goods available for private consumption. Similarly, in the case ot
of an
the necessary
adjustment
elasticities of and 1 ox (and consumption
in the relative
377
DJ.+JI~:
SLOBODAS
increase in the level of anticipated&tire government spending, the increasr in R is again inversely related to 1 /ti and l/e*. III. Current-Account The home country’s between its income
current-account and absorption.
(1.2)
of
Implications
surplus
S = X, -m,
the magnitude
in period
1 is given
by the difference
W-G,.
As shown in <3) and (8>, both Wand m, are functions of R. After substituting these relationships into (12>, differentiating the resulting espression, and using the between J solution for dR provided by (1 l>, we obtain the following relationship and government spending at home and abroad. (13)
dS = -(l +(l
-k)(l -+dG:
-a)dG, -(l
+(l
-1;;)(1
-a)dG,
-ii)adG:,
where 0 defines the size of the home country (relative to the world terms of its ability to absorb disturbances to the supply of goods private consumption. That is <14)
IV*iO*
W/B d = (w/e)+(w*/o*)’
economy) in available for
1 -g
= ([rye) +(IIyO*)’
In this sense, the size of a country is measured by the pro~r/rf of total expenditure (wealth) of the private sector and the elasticity of ICS. the greater its capacity to absorb disturbances, The larger the economy, regardless of whether they originate at home or abroad. Accordingly, in equation (13>, as we consider increasingly higher values of G in the interval from zero to unity, the current-account effect of any given change in government spending at home declines in absolute value from a maximum oi(1 -ri)dG, units of output to a minimum of zero. The same equation reveals that the current-account effect of a shift in foreign spending growr with 0 from a minimum of zero to a masimum of (1 -fi)dG,* units of output. In order to gain some intuition behind this result, let us consider the effects of a temporary increase in government spending at home (dG, > 0). At the original rate of interest, the policy creates an excess demand for present goods equal to dG, -%dG, units of output. The second, negative term reflects the fall in private consumption as households realize that a lump sum tax of dG, units of output accompanies the rise in government spending. Clearly, if the home country is ‘small’ (as measured by o), the policy has only a negligible effect on the world rate of interest. In the limit, as cr + 0, the economy’s excess demand for present goods of (1 -&)dG, units is satisfied through a current-account deficit of the same magnitude. At the other extreme is the case in which the home country is so large that it constitutes the world economy itself (i.e., d = 1). The same temporary increase in government spending now raises the rate of interest to the extent necessary to eliminate internal4 the excess demand for present goods generated by the policy, while the current account remains continuously balanced. In general, the greater the value ofa, the more of any given domestic disturbance
33
Ric(yrtd~y Policies in Open Eionomiri
is absorbed internally and the less of it is ‘esported’ to the foreign country through the current account. ;in application of this same argument from the perspective of the f&-r~~n country can be used to explain the relationship bet\veen G and the current-account implications of fiscal disturbances originating ni~ra&. In terms of the sign of the current-account effect associated with a gil-en policy, (13) reveals that an increase in either G, or G$ gives rise to a period-l deficit for the home country, while an increase in Gy or G2 gives rise to a surplus. These results confirm the popular notion that in order to eliminate the current-account deficit of the L’S economy, there must be either a cut in current government spending in the USA or an expansion in the rest of the world. However, at a more subtle level, the results also reveal that perfect synchronization of fiscal polic) measures across countries may not succeed in preserving current-account balance. In demonstrating this, let us consider the current-account implications of a fullycoordinated temporary increase in government spending. To simplifv the analysis, let us assume that government spending is initially the same fracticjn of GNP in each economy and identical across periods. A coordinated temporary fiscal expansion can then be defined as C/G, ;S=C%: S*> 0, and nG2 =nG* =O. 0) introducing these relationships into (13), we observe that the effect of the police on the current account of the home country is given by
where use was made of the fact that IK’*i_~* =Il~.;_~.8 The espression in (15) is equal to zero only if the elasticities of ICS are the same in the txvo economies. However, if 110 # l$*, the internationally coordinated temporary increase in government spending entails a surplus (deficit) on the current account of the economy with the relatively higher (lower) elasticity of ICS. The intuition behind this result is simple to grasp. We know that a coordinated temporary increase in government spending at home and abroad generates an escess demand for present goods and an escess supply of future goods. This eserts upward pressure on the world rate of interest. ‘-1s r rises to restore equilibrium, the economv with the more elastic intertemporal pattern of consumption eshibits a relatively sharper cut in current private spending. Accordingly, in the new equilibrium with a higher r, this same economy will have a current-account surplus. It can also be shown that the announcement ofa similarly coordinated increase in _/ktzu-c government spending gives rise to a deficit (surplus) on the current account of the economy with the relatively higher (lower) elasticity of ICS. In this case it is the fall in r which stimulates present consumption to a greater estent in the . economy with the relatively more elastic intertemporal spending pattern, resulting in a current-account deficit. IV. Further
Extensions
This section considers three extensions of the basic model. First, it introduces the possibility of trading present for future consumption by means of investing in physical capital. Second, it draws a distinction between domestic and foreign goods, enabling us to study the effects of changes in government spending on the terms of trade. Finally, it extends the basic model by introducing non-traded goods into the analysis.
SLOBOD.+X DJ.IJI~
3-9
1 I T_-I. Intrrtrmporal Production Shtitrrtion
The assumption that output is exogenous in each period may be relaxed in favor of a more general specification of the supply side. For example, if the possibility of investment offers the economy an opportunity to increase the supply (S,) of goods available for household and government consumption in the second period at the espense of that available in the first period (S,), u-e may define the intertemporal transformation functions of the two economies b! (16)
A-> = _f(.Y, ),
SF
= f‘“(‘YI*)
decreasing and strictly concave.g In the event wheref‘( .) andf*( .) are continuous, that production technologv or the institutional framework governing investment decisions is not the same in’the two countries, the elasticity of f‘( .) may differ from that ofJ*( e) in the neighborhood of the initial equilibrium (Ix., the point on f‘( .) 1 and on f‘*( .) at which f“( .) =_/‘*‘( *) = -l/R). \‘‘aturally, the economv with the relatively more elastic intertemporal transformation function exhibits a relatively greater supply response to changes in the world rate of interest in the same nay that the economy with the relatively larger elasticity of ICS exhibits a relatively greater Since the current account reflects the gap between the demand response. economy’s supply and demand for goods in a given period, the current-account implications of being the economy with the relatively higher elasticity of ICS are with the relatively more elastic very similar to those of being the economy intertemporal transformation function. In illustrating this point. let us consider a situation in which the world rate of interest is pushed up due to a (coordinated) temporary increase in go\-ernment expenditure both at home and abroad. Let us assume further that the two economies differ only in terms of the elasticities of their intertemporal transformation schedules. Since the economy with the higher elasticity exhibits a relatively largerdrcline ininrrstmmtztspending in response to the increase in I-, it enjoys a current-account surplus.
I1 /.B. Two-Commodity World
Another way of generalizing the model of Section I is by drawing a distinction between the domestic and the foreign goods. This distinction introduces an important variable into the analysis: the relative price of domestic in terms of foreign goods or the commodity terms of trade. To get some flavor of the importance of the elasticity of ICS in this more general setting, let us consider the simplest possible two-commodity extension of our model. In particular, let the consumption index C, in equation take the form, (17)
C, = H;F;-‘,
O
where r is the (constant) share of domestically produced good (H), and 1 -x is that of the foreign good (F) in total expenditure of domestic residents. The foreign consumption index CF is similarly defined, with an asterisk signifying foreign variables. In order to highlight the role of intertemporal consumption substitution in the relationship between public expenditure and the terms of trade, let us suppose:
_%I,
BdKcfay
Policies in Oprn Economies
(a) that the HF composition of government spending in each economy is identical to that of the economy’s household spending, (b) that government spending is initially the same fraction of GNP in each economv and identical across periods, and (c) that fiscal measures are internationally coordinated in the sense that an increase in government spending at home in p&iod t is accompanied by an identical increase (as a percentage of GNP) abroad. A temporary increase in government spending of this type lowers the relative price of domest.ic in terms of foreign goods in the economy with the relatively higher elasticity of ICS, provided the espenditure share of domestically-produced goods is larger at home than it is abroad.‘” What is the intuition behind this result? On the basis ofthe discussion in Section III, it should be clear that the country with the relatively higher elasticity of ICS develops a current-account surplus in response to a coordinated temporary fiscal espansion while the other economy develops a corresponding deficit. Thus, in the former economy, espenditurc (private plus public) fblls relative to income in the first period while it increases in the latter economv. If residents of each countr! have a relatively stronger preference for the locally-produced good, at the original terms of trade there emerges an excess supply in the first period of the good produced in the country with the higher elasticity of ICS and an escess demand for the good produced by the other country. In order to restore equilibrium, the relative price of the good produced in the economy with the higher elasticity of ICS must fall in period 1. An analogous argument can be used to show thar the relative price of this same economy’s good must rise in period 2. If a similarly coordinatedfr,tctrr increase in government spending is .lnnounced, the terms-of-trade effects are esactly the opposite. For the economlwith the relatively higher elasticitv of ICS, the current (future) terms of trade improve (deteriorate).
I I ‘.C. Lh’on-Tradd
Goods
Finally, let us consider the version of our model in which H, in equation (17) is interpreted to be the rate of consumption of an internationally non-traded good and F, as the rate of consumption of a single traded commodity. In order to focus once again on the role of intertemporal consumption substitution, let us suppose that, in addition to assumptions (a) and (b) of the previous subsection, a concave, timeinvariant production-possibilities frontier relates the output of traded to that of non-traded goods in each economy. It can then be shown that an internationallycoordinated (in the above sense) temporary increase in government spending raises the current and lowers the future relative price of traded in terms of non-traded goods in the economy with the higher elasticity of ICS. Because the economy with the higher elasticity is the one in which expenditure falls relative to income in period 1 and rises relative to income in period 2, the relative price of traded in terms of non-traded goods must increase in this economy in the first period and fall in the second period. I1 Of course, the opposite relative price changes occur in the economy with the relatively lower elasticity of ICS. There are important implications of these opposing relative-price movements: on the supply side, shifts in the allocation of productive resources between traded and non-traded sectors are in one direction at home and in the opposite direction abroad. In addition, because the relative price of traded in terms of non-traded
SLOBOD.W T.IBLE I. Government
Cnited States European Four major countriesb Total OECD itw the United States
tinal
381
DJ.IJI~
consumption
as percentage
of GDP.”
1978
19-9
1981)
1981
1982
1083
1981
I?.7
l-.6
18.3
18.2
19.2
19.3
18.8
17.8
l-.8
18-l
19.2
19.3
19.4
19.-I
15.8
15.9
16.5
16.7
16.9
16.8
16.5
’ Government tinal consumption expenditure mainI!- consists of current purchases of goods and services for public administration, defence, health and education. It excludes all transfer payments. b Germany, France. United Kingdom and Italy. Soan~ q‘n’uf~: Table RG. OECD, EMMWM~L 011/o&, December 1985.
goods falls (rises) between periods 1 and 2 in the economy with the higher (lower) elasticity of ICS, its consumers face a real rate of interest -stated in terms of the representative household’s consumption basket -which is lower (higher) than the real rate of interest measured in terms of traded go0ds.l” Thus, following a coordinated temporary increase in government spending, one should expect to observe that the consumption-based real rate of interest is lower in the economy with a current-account surplus than it is in the economy with a deficit. V. Concluding
Remarks
Some previous studies have attempted to esplain current-account fluctuations on the basis of models which highlight distinctions between domestic and foreign fiscal measures. While tax policies of countries have deviated very signiticantly from one another over the last few years, the data presented in Table 1 seem to indicate that changes in the time profile of government consumption have been quite similar. To the extent that these expenditure changes are espected to remain in effect for the same period of time, and to the esteut that Ricardian eqhalem-e holds, some of the recent developments may reflect asymmetric reactions of countries to a common set of policies rather than adjustment to policies implemented in just one of the countries. In pursuing this line of investigation, we have found that the experience of the USA over the last few years (including a current-account deficit, an improvement in the terms of trade, a fall in the relative price of traded in terms of non-traded goods, and an increase in the consumption-based real rate of interest relative to the traded-goods rate) is qualitatively similar to that of an economy with a relatively low elasticity of ICS responding to a temporary increase in government spending both at home and abroad.
Notes 1. See, e.g., hizenman (1983), Buiter (1986). Djajii (1985). Frenkel and Razin (1985, 1986a, 1986b), Greenwood and Kimbrough (1983). Persson (1983), and van K’ijnbergen (1985). The recent paper by Marion and Svensson (1986) is of related interest. 2. In the context of small-country models, the importance of this elasticity is illustrated by Dornbusch (1983), Obstfeld (1983, 198j), and Djajic (1986). among others. Giovannini (1984) distinguishes between domestic and foreign elasticities in the context of a two-country, uncertainlifetime model of capital accumulation.
3 Several ‘Ittempts have been made to estimate the value of this elnsticlty on the basis of L‘S data: Hall (1981) has reported a value ofabout I 15, Alankiw : 1051)ofabout I 4. Hansen and Singleton (1982) in the range betueen I and 1.5, and ,\l.lnkiu rt ‘ii. j 1985)h.lvr rrpc~rtedvaluesanthe range bet\veen I and II). The contlicting nature of these iindlnps retlects the very serious estimation problems lvhlch exist, as \vell as the problems of m<.lsuring consumption, expected lifetime income, rates of return, and other key variables. I am nor a\vare of any multi-country studies of this tvpr, other than the one by Giorannini (198-l) \vhich reports ver)- lo\v estimates of the rlasti&r of ICS for a number of LDCs. One should note, ho\vever. th.lt problems \vith LDC data are even more serious than those uith the YS data. The assumption that the public-sector budget is balanced in each period is made without any loss of generality. In a world such as the one analpsed here, a s\ritch from lump-sum-tax to debt finance has no effect on the economy’s current accc~nt nor on any of the variables interest in the remainder ofthe paper. For further discussion ofthis ‘Ricardinn equivalence’ protwsition, see Bnrro (10-4). by using equation ( II)). the detinttl,lns of W’and II..* in (3) and (4). and the 3. It can be obtained fact that ,,I, + KN+ = I. if\ve relaxed the assumption that ci is independent ofthe level 6. There Lvould be an effect, ofcourse, ofwelfareenioyed by the household. On this, see Obstfeld (1982) and S\-ensson and Rnzin (198.3). There is also an interesting issue of uhether one should assume th.lt agents are able to insure themselves against unforeseen changes in tiscal policy-. To the extent that agents participate in such insurance markets, some of the conclusions of the present paper lvould be affected. For an analysis of this problem, see Stockman (1086). Effects of exogenous changes in output can be esnmlned to confirm the familiar result that dK ‘?f.Y, =dR,‘d,Y: = -&dG, = -dR/dG:. 8. \\‘e kno\v that lI~‘;.~=(l + R)[ 1-~?;.y] and K” ,y* = I + K)[ 1--c- ,y*] \vherc c and c* are the initial rates of government spending in the t\vo economies over the t\vo periods. Since t?*i \vas assumed equal to c* .y* K’,l.y= W’*;,t’*. 9. See, for example, Bruce and Pirvis (1985) and Sachs (1~181) for a more extensit-e analysis of the role of investment in a similar setting. happen to have the relatively stronger preference for the good produced IO. If foreigners in the home county, the reverse is true. of the inverse relationship between an economy’s absorption and II. For a more extensive discuwon its relative price of traded in terms of non-traded goods see, e.g., Dvrnbusch (1983) and Razin (198-y. (1983), r,, the real rate of interest measured in terms of the economy’s 12. As shown by Dornbusch consumption basket (assuming preferences are defined by equations (I) and (I->, nhere Hand F represent consumption of non-traded and traded goods, respectively) is given by r, = (1 +r)(P,iP&‘-I, where r is the world rate of interest measured in terms of traded goods and I-‘, is the relative price of traded in terms of non-tr.aded goods in period t. If I-‘, > I’,, r,< r and U~CPLYT~~Z, as stated in the test. See Devereus (1956) for a more detailed stud!- of a twocountry extension of the Dornbusch (1983) model.
of
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