Determinants of external imbalances between large economies

Other Publications Julia Niemeläinen

Abstract

This dissertation consists of an introduction and three essays on the determination of external imbalances and the real interest rate. In particular, the objective of the dissertation is to analyze the reasons behind the long-lasting current account imbalances observed over the past decades in large open economies, such as the current account deficit of the United States and the current account surplus of China, as well as the concurrent long-term decline in the world real interest rate.

In the first two essays, I focus on demographic change, social security and fiscal policy as potential drivers of households’ consumption-saving decisions, the current account and the world real interest rate. The analysis is based on a dynamic general equilibrium model with an embedded life-cycle structure, which allows me to study the role of life-cycle savings and intergenerational transfers in the consumption-saving decisions, and in which fiscal policy is non-Ricardian.

In the first essay I analyze how permanent differences in demographics, social security and fiscal policy affect the external sector and the world real interest rate in the long run, and compare the effects under fixed and variable labour supply, which the literature on demographic change and external imbalances often abstracts from. I find that, relatively high life expectancy and low social security are associated with a positive net foreign asset position in the two-country world. Because the impact of social security is quantitatively large, a country with relatively low life expectancy may become a net creditor if its social security is low enough. This result suggests that analyzing the effects of social security could help us understand the observed low-frequency capital flows from fast-growing emerging economies to industrialized countries. High life expectancy is, in the model, associated with a low international real interest rate, but endogenizing labour supply results in a higher real interest rate for a given level of life expectancy. This indicates that the negative effect of population ageing on the real interest rate might not be as strong as suggested by several earlier studies.

The objective of the second essay is to analyze whether it is possible to replicate the dynamics of China’s trade surplus vis-a-vis the United States over the period 1980-2015, by taking into account the differences in demographic factors and social security between the countries. Productivity growth in China has been approximately twice as rapid as in the United States during this period, which, according to traditional neoclassical models, should imply high investment and consumption rates, and result in a trade deficit. In my model, China’s relatively rapid population ageing and low social security result in high and increasing savings by Chinese households, so that even when China’s high productivity growth is taken into account, the model produces a trade surplus for China during the sample period.

In the third essay, I analyze the impact of the Chinese government’s macroeconomic policies on the observed trade balance dynamics and the transmission of these policies to the United States in the 2000s. The analysis is based on a life-cycle model, which includes features that describe the behavior of the Chinese policymakers. In particular, I assume that private agents are excluded from the international financial market, and that the public authorities can directly control the domestic real interest rate and the real exchange rate. I find that macroeconomic policies, especially the undervaluation of China’s real exchange rate, and the growth in government expenditures and fiscal deficits run by China and the United States, have had a positive impact on China’s trade balance, and raised the international interest rate. However, the overall effect of the policies depends qualitatively on the assumption of the elasticity of intertemporal substitution.

Publication Information

Niemeläinen, J. (2020), Determinants of external imbalances between large economies, Publications of the Helsinki Center of Economic Research, No. 1/2020.

  • ISSN: 2323-9786 (Print), 2323-9786 (Online)
  • ISBN: 978-952-10-8758-5 (Print), 978-952-10-8759-2 (Online)
  • JEL: E21, E22, E43, E62, F21, F32, F41, F42, G28
  • Press Release in Finnish