Seminar

Domestic or global imbalances? Rising inequality and the fall in the US current account

Tobias Broer (IIES Stockholm)

October 19, 2009, 17:00–18:30

Toulouse

Room MF 323

Political Economy Seminar

Abstract

This paper shows how the rise in individual income risk in the US since the 1980s might help explain the fall in its foreign asset position. The key to this result is endogenous financial deepening in an open economy with participation-constrained domestic financial markets. More volatile income makes individuals less inclined to default on financial contracts as this triggers exclusion from future financial trade. Lower incentives to default, in turn, increase the insurability of income shocks, thus lowering the need for precautionary savings. My theoretical results show that, contrary to the case of unconstrained complete markets, individual participation-constraints guarantee a well-defined stationary equilibrium at a given world interest rate. Based on an analytical solution to the stationary consumption distribution, I show that higher income risk can lower mean consumption and aggregate asset holdings. Consumption inequality, on the other hand, is almost entirely determined by the level of world interest rates, and remains largely unaffected by changes in income risk. A quantitative exercise shows that the observed rise in individual income risk in the US since the 1980s can explain a significant fall in net foreign assets.

JEL codes

  • D31: Personal Income, Wealth, and Their Distributions
  • D51: Exchange and Production Economies
  • E21: Consumption • Saving • Wealth
  • F21: International Investment • Long-Term Capital Movements
  • F41: Open Economy Macroeconomics