CURRENT ACCOUNT MODEL:

Assumptions:
T- period model.
Agents have access to global markets. Can borrow or lend at some constant interest rates r. We'll have
an endowment economy. At each period t, there's a some amount of GDP that is already known (Y_t). At
each period, we know hat our GDP is. Take it as given.
We're also going to take investment at any point in time and government expenditure as given. I_t and
G_t are exogenous.

Household will have to make a decision on how much to consume at each period.
We can also have 1 period bonds. Period by period bonds.
At any period t, there's some budget constraint. Income sources are Y_t (gdp) + (1+r) B_t = C_t + I_t +
G_t + B_t+1
B_t are bonds purchased a period before but pay at period t.
Buy bonds at period t but pays at period t+1. If its positive, you borrow. If its negative you're lending.
These are international, foreign bonds.

Additional assumptinos:
T = 2 (There are two periods)
I_1 = I_2 = G_1 = G_ 2 = 0 (Investment and government expenditure is zero)
B_1 = 0 (When universe was bornin period 1, we're born without any asset or any debt). Bond
purcahsed at zero and pays at period 1.
U = u(C_1) + beta * u (C_2) Utility in period 1 and utility in period 2
What is beta? Preference for future consumption. How much we value consumption today vs
consumption tomorrow. Always assume that beta is smaller than 1. Beta < 1.
The first derative of C1 --> U' (C_1) > 0 . The more cookies we consumed, the happier we are. U'' (C_1) <
0. Diminishing marginal utilty. Strictly concave utility function.

At period 1: t =1 , Y_1 = C_1 + B_2

We can consume or buy bonds that will pay in period 2.

At period 2: t=2, Y_1 + (1+r)(B_2) = C_2 + B_3
However, we assume that t=2, therefore, B_3 =0. We're going to consume all.

Put the two equations together.

From the budget constraint t=1, B_2 = Y_1 - C_1

Introduce this to period 2, t=2
*** Y_2 + (1+r)(Y_1-C_1) = C_2
This is very hard to interpet right now. Transform this into something we can understand. Put GDP and
Consumption on other sides.
(1+r)(Y_1) + Y_2 = (1+r)(C_1) + C_2

Divide both sides by (1+r)

Y_1 + Y_2 / (1+r) = C_1 + C_2 / (1+r)

This is the intertemporal budget constraint. Lifetime income is equal to the lifetime income of our
consumption. Present discounted value. Household has to decide how much they consume today and
they consume tomorrow. They maximize their utility function subject to this intertemoral budget
constraint. We maximize this problem.

How do we solve it?

Current Account Model

T period model

Y_t + (1 + r) B_t = C_t + I_t + G_t + B_t+1

CA_t = B_t+1 - B_t = - FA_t
Current account is the same as minus fianncial account. There's a one to one relationship between
trading of financial asset and trading goods. This should be equal. This definition also satfisfies the two
other definition of current account.
B_t+1 - B_t = Y_t + rB_t - C_t - I_t - G_t
- FA_t = (Y_t - C_t - I_t - G_t) + rB_t --> rB_t is interest payment. Therefore, ti qualifies as net factor
payment.
= NX_t + NFP_t
CA_t = (Y_t + rB_t) - C_t - I_t - G_t
= (Q_t - C_t - G_t) - I_t
= S_t - I_t

2 Period Model

Y_1 = C_1 + B_2

Y_2 + (1+r)B_2 = C_2 > Y_1 + (Y_2 / (1+r)) = C_1 + (C_2 / (1+r)) eqn 1

U' (C_1) = beta (1 + r) * u'(C_2)

If beta*(1+r) = 1 --> C_1 = C_2 = Cbar
Substitute this into equation 1
Cbar = ((1+r)/(2+r)) * (Y_1 + (Y_2/(1+r)) )

BENCHMARK

Y_1 = Y_2 = Ybar ---> C_1 = C_2 = Ybar.

Income is constant over time .
Consumption level should be the same over time except if i consume it all today. Present discounted
value of my income is the same as the presented value of my consumption. What's going to be the
current account at this case? We have no reason to buy or sell any financial asset. Current account
would be balance. I.E: CA = 0.

No incentive to go to the international market. Want to consume already.

1) Y_1' > Ybar --> C_1 = C_2 > Ybar

Therefore, we are going to lend some money out.
My income today is above Ybar. My income will be Ybar. Look at the intertemporal budget constraint.
Present value of income has gone up. Therefore, present value of consumption has to go up. We are
richer, therefore, we have to consume more but we want to consume the saem each period. This mean
that our consumption in the two period is going to increase.

Lend something this period and receive interest in the second period and consume more in the future.
Therefore, this smooth the consumption. Therefore, current account surplus: CA_1> 0.

Income goes up and i'm richer. My total consumption (pv of consumption) is going to go up but we want
to smooth. Therefore, they both have to increase. Save some money and smooth consumption over
time.

2) Y_2 ' > Ybar --> C_1 = C_2 > Ybar ; CA_1 <0
We want to smooth consumption over time. This is irrelevant of our income. PV of income goes up.
Therefore, PV of consumption has to go up as well. Borrow from the rest of the world. Therefore,
current account deficit.

3) Y_1 '' = Y_2 '' = (1 + alpha) Ybar --> C_1 = C_2 = (1+alpha)Ybar > Ybar

My income and tomorrow increase by alpha percent. Consumption will go up by alpha percent.
Consume more of our income. Current account is balanced. CA_1 = 0
This is a permenent shock whereas the other is a temporary account.

CURRENT ACCOUNT MODEL

CA_1 = B_2 - B_1 = Y_1 - C_1 = Y_1 - ((1+r)/(2+r)) * (Y_1 + (Y_2/(1+r)) )
= [ (2 + r)Y_1 - (1+r)Y_1 - Y_2 ] / (2+r)
= [ Y_1 - Y_2 ] / (2 + r)
One of our assumption that we are born with zero bond. Therefore, B_1 = 0
Depending on income today and incoem tomorrow, this determine the sign of the current account.
Therefore, tne numerator of the equation determine the current account sign.