Capital Flows, Interest Rates and Precautionary Behaviour: A Model of Global Imbalances

WEFRP Working Paper No. WEF 0014

38 Pages Posted: 31 Oct 2006

See all articles by Marcus H. Miller

Marcus H. Miller

University of Warwick - Department of Economics; Institute for International Economics; Centre for Economic Policy Research (CEPR)

Lei Zhang

University of Warwick - Department of Economics

Date Written: July 2006

Abstract

A dynamic stochastic model of global equilibrium, where countries outside the U.S. face higher risk than the U.S. itself, predicts current account surpluses in the RoW and U.S. 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 U.S. 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 U.S., might it not lead to the inefficient outcomes forecast by several leading macroeconomists? When precautionary saving is combines with financial panic, history offers no guarantee of full employment.

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

JEL Classification: D51, D52, E12, E13, E21, E44, F32

Suggested Citation

Miller, Marcus H. and Zhang, Lei, Capital Flows, Interest Rates and Precautionary Behaviour: A Model of Global Imbalances (July 2006). WEFRP Working Paper No. WEF 0014, Available at SSRN: https://ssrn.com/abstract=941391 or http://dx.doi.org/10.2139/ssrn.941391

Marcus H. Miller (Contact Author)

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom
+44 24 7652 3048/9 (Phone)
+44 24 7652 3032 (Fax)

Institute for International Economics

1750 Massachusetts Avenue, NW
Washington, DC 20036-1903
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Lei Zhang

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom
+44 24 7652 2983 (Phone)
+44 24 7652 3032 (Fax)

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