Exercise 6.3 (Global Uncertainty) Suppose that, for a host of reasons, part of t

Question

Exercise 6.3 (Global Uncertainty) Suppose that, for a host of reasons, part of the world suddenly becomes more uncertain (think of wars, political instability, economic crises, etc.). Refer to this group of more uncertain countries as UC. Assume that the increase in uncertainty is manifested in a higher standard deviation of future output. Refer to the rest of the world as ROW. Analyze the effect of this increase in uncertainty on the world interest rate and on consumption, savings, and the current account in the UC and the ROW. You might want to accompany your explanation with one or more graphs.

Explanation / Answer

Dear sir / madam, the life cycle hypothesis is that people save largely to finance retirement. However, additional savings goals also matter. Some saving is done to provide inheritances for children. Some saving is precautionary, undertaken to guard against rainy days . Savings are used as buffer stock, added to when times are good in order to maintain consumption when times are bad. Evidence for these other movements is that old people rarely actually save. They tend to live off the income ( interest and dividends) from their wealth- not to draw down wealth. The older they are, the more they fear having to pay large bills for medical care and therefore, the more reluctant they are to spend. Evidences are that savings is undertaken to meet emergency needs. Due to the reasons given in the question, income fluctuations create considerable downside risk for the consumer , because the pain caused by a large drop in spending is greater than the pleasure caused by an equal size increase in spending. One way consumers can avoid having to cut their consumption sharply in bad times is to save up a buffer stock of assets, which they can draw on in emergences due to problems in social conditions due to decrease in output and thus, investment referred in the question. On the other hand, most consumers are impatient, they would prefer to spend now rather than save for the future. Thus, consumers will have a target wealth level. The target will be the point where impatience exactly balances the precautionary ( or buffer stock) saving motive. If the wealth is below the target, the precautionary saving motive will be stronger than impatience and the consumers will try to build up wealth toward the target, if wealth is above the target, impatience will be stronger than caution and the consumer will dissave. These effects lead to a much higher MPC than would be predicted for life cycle hypothesis.

The interest will be high in UC and low in ROW and hence people will consume more in UC and save more in ROW. Balance of payments would be a bad shape in UC as govt. would have to import more and export less. There would be inflation in UC and govt. borrowings would be more as home production would suffer in UC and hence lower income. There would be depreciation of UC currency and this would lead to devaluation.

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