Consumption Smoothing Channels in Open Economies

We recognize that intertemporal models of the current account (Frankel and Razin with Yuan 1996, or Baxter and Crucini 1993) imply a theory of consumption smoothing channels, and thus we build an empirical model on the theoretical foundations of Sachs (1982)'s optimizing model in order to analyze the intertemporal smoothing role of saving components (fixed investments, inventories and trade balance). The estimation is conducted in a structural VAR framework, in which the minimal identifying restrictions are consistent with both the 'intertemporal approach to the current account' and the empirical consumption smoothing literature. Through the use of impulse response functions following different types of shocks, we find that for the OECD countries the bulk of intertemporal smoothing has been carried out domestically, through gross fixed investments and inventories, but the trade balance has also played a relevant - albeit volatile - smoothing role. We also determine the dynamic role of each component: the trade balance and inventories are mostly used as short-run smoothing tools while fixed investment provides more and more smoothing over time. Since our framework can accommodate various models of the current account, we can address some empirical puzzles, such as the 'excess sensitivity of investment' anomaly (Glick and Rogoff, JME 1995) and the 'saving-investment puzzle' (Feldstein and Horioka, EJ 1980).