Introducing house prices to the intertemporal current account model: An application to the European Union

Abstract

The last 30 years have been marked by significant and persistent external imbalances. To examine the relationship between the current account balance and its determinants, particularly house prices, we extend the intertemporal model of the current account. We introduce the prices of durables to the theoretical model to account for house prices. In addition to house prices, the theoretical model also incorporates fiscal balance, income, investment, and government spending to explain external imbalances. We test the model for the European Union's member states between 2000 and 2019 using a system generalized method of moments model, which performs well empirically as the coefficients are significant and have the predicted sign. Our findings indicate that rising house prices exacerbate the current account balance due to the wealth effect on consumption. Within the European Union, house prices have the most negative impact on the current account balance in Central and Eastern European countries. • We examine how house prices affect the current account balance. • We add the prices of durables to the intertemporal model of the current account to account for house prices. • We apply the theoretical model to EU countries from 2000 to 2019 using the system GMM estimator. • We find that rising house prices worsen the current account balance through the wealth effect on consumption. • The impact of house prices on the current account differs significantly in CEEC when compared to other EU member states.