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Capital Flows, Interest Rates and Precautionary Behaviour: a model of "global imbalances"

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  • Marcus Miller

    (University of Warwick)

  • Lei Zhang

    (University of Warwick)

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 ESRC World Economy and Finance Research Programme, Birkbeck, University of London in its series WEF Working Papers with number 0014.

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Date of creation: Jul 2006
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Handle: RePEc:wef:wpaper:0014

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

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  1. Caballero, Ricardo J. & Farhi, Emmanuel & Gourinchas, Pierre-Olivier, 2008. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," Scholarly Articles 3229094, Harvard University Department of Economics.
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  10. E. Kohlscheen & M. P. Taylor, 2008. "International liquidity swaps: is the Chiang Mai Initiative pooling reserves efficiently?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 13(4), pages 323-332.
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  13. Christopher D. Carroll & Jody Overland & David N. Weil, 1995. "Saving and growth with habit formation," Finance and Economics Discussion Series 95-42, Board of Governors of the Federal Reserve System (U.S.).
  14. Marcus Miller & Olli Castrén & Lei Zhang, 2007. "'Irrational exuberance' and capital flows for the US New Economy: a simple global model," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 12(1), pages 89-105.
  15. Michael P. Dooley & David Folkerts-Landau & Peter Garber, 2004. "The revived Bretton Woods system," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 9(4), pages 307-313.
  16. Driffill, John & Snell, Andrew, 2003. " What Moves OECD Real Interest Rates?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 35(3), pages 375-402, June.
  17. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries," IMF Working Papers 06/229, International Monetary Fund.
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