Lecture 1B: Common mistakes and summary

Common mistakes

• Confusing CA and TB: the trade balance is only one part of the current account.
• Confusing flows and stocks: the CA is a yearly flow; the NIIP is a stock at a moment in time.
• Thinking ΔNIIP always equals the CA: valuation changes can be larger than the CA.
• Thinking a bilateral deficit is the problem: the total CA depends on saving minus investment, not on one trading partner.
• Forgetting the real rate in the Taylor principle: what matters is whether the nominal rate rises by more than inflation.
• Mixing up the floor and the ceiling: the deposit rate is the floor, the lending rate the ceiling.

Summary

• Central banks steer one short-term interest rate. They keep the market rate inside a corridor between their deposit rate (floor) and lending rate (ceiling); the floor leaks because non-banks lack access (the Fed fixes this with the ON RRP). With ample reserves after QE, they set the rate (price) directly instead of the quantity of reserves.
• The Fed has a dual mandate (jobs and prices, 2% PCE); the ECB a primary objective (prices, 2% HICP, symmetric).
• The Taylor rule i = r* + π + 0.5(π − π*) + 0.5y describes policy; the Taylor principle demands an inflation coefficient above 1. Its prescription depends strongly on the inflation measure, r*, the gap and smoothing.
• Global imbalances: the US is a large net debtor; Germany, Japan and China are large net creditors.
• Balance of payments: current account + capital account = financial account. CA = TB + income balance + net unilateral transfers; for most countries the TB dominates.
• NIIP = A − L; it changes through the CA and through valuation changes (exchange rates and asset prices), which have become large because gross positions grew.
• The NIIP-NII paradox (US: NIIP < 0, NII > 0) is explained by dark matter or return differentials (exorbitant privilege); China shows the inverted paradox.
• Next lecture: the New Keynesian model and why the Taylor rule approximates optimal policy; later, whether current account deficits are sustainable.