Instead of trading one good for another at a point in time, we exchange goods today in return for some goods in the future. This kind of trade is known as inter-temporal trade. Even in the absence of international capital movements, any economy faces a trade-off between consumption now and consumption in the future.
Economies usually do not consume all of their current output; some of their output takes the form of investment in machines, buildings, and other forms of productive capital. The more investment an economy undertakes now, the more it will be able to produce and consume in the future. To invest more, however, an economy must release resources by consuming less (unless there are unemployed resources, a possibility we temporarily disregard). Thus there is a trade-off between current and future consumption.
The shape of the inter-temporal production possibility frontier will differ among countries. Some countries will have production possibilities that are biased toward present output, while others are biased toward future output. We will ask in a moment what real differences these biases correspond to, but first let’s simply suppose that there are two countries, Home and Foreign, with different inter-temporal production possibilities. Home’s possibilities are biased toward current consumption, while Foreign’s are biased toward future consumption. The inter-temporal relative supply curves for Home and Foreign reflect how Home’s production possibilities are biased toward present consumption whereas Foreign’s production possibilities are biased toward future consumption.
In other words, Foreign’s relative supply for future consumption is shifted out relative to Home’s relative supply. At the equilibrium real interest rate, Home will export present consumption in return for imports of future consumption. That is, Home will lend to Foreign in the present and receive repayment in the future.
Home’s inter-temporal production possibilities are biased toward present production. But what does this mean? The sources of inter-temporal comparative advantage are somewhat different from those that give rise to ordinary trade. A country that has a comparative advantage in future production of consumption goods is one that in the absence of international borrowing and lending would have a low relative price of future consumption, that is, a high real interest rate. This high real interest rate corresponds to a high return on investment, that is, a high return to diverting resources from current production of consumption goods to production of capital goods, construction, and other activities that enhance the economy’s future ability to produce.
So countries that borrow in the international market will be those where highly productive investment opportunities are available relative to current productive capacity, while countries that lend will be those where such opportunities are not available domestically.
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