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Capital Flows, Interest Rates and Precautionary Behaviour: a model of Global Imbalances

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  • Marcus Miller

    (Warwick University)

  • Lei Zhang

    (Warwick University)

Abstract

A dynamic stochastic model of global equilibrium, where countries outside the US face higher risk than the US itself, predicts current account surpluses in the RoW and US deficits. With Loss Aversion, such precautionary savings can cause substantial ‘global imbalances’, particularly if there is an inefficient supply of global ‘insurance’. In principle, lower real interest rates will ensure aggregate demand equals supply at a global level (though the required real interest may be negative). Low interest rates and high savings outside the US appear to be an efficient global equilibrium: but is this sustainable? A precautionary savings glut appears to us to be a temporary phenomenon, destined for correction as and when adequate reserve levels are achieved. But if the process of correction is triggered by ‘Sudden Stop’ on capital flows to the US, might it not lead to the inefficient outcomes forecast by several leading macroeconomists? When precautionary saving is combined with financial panic, history offers no guarantee of full employment.

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Bibliographic Info

Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 152.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:152

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Keywords: stochastic dynamic general equilibrium; loss aversion; liquidity trap;

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