Abstract
Abstract The present value model of the current account has been very popular, as it provides an optimal benchmark to which actual current account series have often been compared. We show why persistence in observed current account data makes the estimated optimal series very sensitive to small-sample estimation error, making it almost impossible to determine whether the consumption-smoothing current account tracks the actual current account closely, or not closely at all. Moreover, the standard Wald test of the model will falsely accept or reject the model with substantial probability. Monte Carlo simulations and estimations using annual and quarterly data from five OECD countries strongly support our predictions. In particular, we conclude that two important consensus results in the literature – that the optimal series is highly correlated with the actual series, but substantially less volatile – are not statistically robust.
Highlights
The intertemporal approach to the current account first popularized by Sachs (1981) views net accumulation of foreign assets as a way for domestic residents to smooth consumption intertemporally in the face of idiosyncratic income shocks.1 The intertemporal approach has been very popular over the last two decades
Under some simplifying assumptions and using a methodology developed by Campbell and Shiller (1987) in a different context, one can estimate the current account series that would have been optimal from a consumption smoothing perspective
Numerous academic papers have looked at both emerging and industrial countries, and a consensus has emerged from this literature: while the model-predicted current account is positively correlated with the actual series, the latter is substantially more volatile, leading statistical tests to reject the model
Summary
The intertemporal approach to the current account first popularized by Sachs (1981) views net accumulation of foreign assets as a way for domestic residents to smooth consumption intertemporally in the face of idiosyncratic income shocks. The intertemporal approach has been very popular over the last two decades. The intertemporal approach to the current account first popularized by Sachs (1981) views net accumulation of foreign assets as a way for domestic residents to smooth consumption intertemporally in the face of idiosyncratic income shocks.. Starting with Sheffrin and Woo (1990), economists have been eager to compare actual current account data with this optimal benchmark.. Numerous academic papers have looked at both emerging and industrial countries, and a consensus has emerged from this literature: while the model-predicted current account is positively correlated with the actual series, the latter is substantially more volatile, leading statistical tests to reject the model.. More recent papers have tried to “augment” the model in several directions to generate extra predicted volatility. Gruber (2004) generates extra volatility in the predicted series by way of habit formation and excess smoothness in consumption. More recent papers have tried to “augment” the model in several directions to generate extra predicted volatility. Bergin and Sheffrin (2000) show that allowing for variable real exchange rates and interest rates improves the fit of the model for Australian, Canadian, and British data. Gruber (2004) generates extra volatility in the predicted series by way of habit formation and excess smoothness in consumption. Nason and Rogers (2006) test competing additions to the model and find that exogenous shocks to the world real interest rate best reconcile the extended model with Canadian data
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