Question

Exercise 5.10: In a recent article, John Bluedorn" investigates how the current account position of small Caribbean and Central American economies react to ‘hurricane shocks.' Hurricanes are not infrequent events in these parts of the world. When they hit, they invariably lead to a transitory decline in real per capita GDP (at least, controlling for several other factors). The author finds that the current account position of these economies first falls and later increases in response to a hurricane shock. Is this feature of the data consistent with our theory? Explain.

Answer 1

The general equilibrium model, arguably the most essential outcome of economic theory till date, shows that under the presumption of complete markets (i.e. completely developed insurance & financial markets), persons are able to trade risk so that income fluctuations don’t result in fluctuations in consumption . In such a model, persons have recourse to well-developed national & international insurance & financial markets to alleviate the effect of production shocks on level of consumption so that the remaining shocks to consumption are global in nature that aren’t diversifiable away . But, in fact, fluctuations in income do convert into fluctuations in consumption in case the risk management mechanisms aren’t well developed . In this context, consumption volatility comes from production shocks which are converted into consumption shocks mostly due to ineffectual risk-management mechanisms . The production shocks may be national/ external in origin. National shocks can result from insufficient macroeconomic strategies / from destabilizing occurrences such as civil unrest/ armed insurrections / civil wars. External shocks can be in the form of natural hazards/ international disputes / terms of trade shocks / global shocks from worldwide recessions & booms.

Governments indeed play a positive part in lessening overall consumption volatility or in smoothing overall consumption by providing more public goods in times of low private consumption. In the Caribbean area, the volatility of overall consumption is 8.6 %, whilst that of private consumption is 10.6%. Nonetheless, the countercyclical role of public consumption varies across nations.

Smaller economies are likely to suffer from greater consumption volatility than bigger economies. Smaller nations are less able to exploit economies of scale as their production isn’t diversified. As far as Caribbean countries are concerned, their size makes them susceptible to the aftermath of hurricanes etc. Also, big industrial economies may not suffer from considerable output losses as regional / asymmetric shocks from calamities may be absorbed by economic activities in other areas & transfers across areas.