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Testing present value models of the current account: a cautionary note

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  • Kasa, Kenneth

Abstract

Following Campbell (1987) and Campbell and Shiller (1987), many papers have evaluated the intertemporal approach to the current account by testing restrictions on a Vector Autoregression (VAR). The attractiveness of the Campbell-Shiller methodology is that it is thought to be immune to omitted information. This paper uses results from Hansen and Sargent (1991a) and Quah (1990) to show that this is not true in certain (empirically plausible) situations. In particular, it is shown that if fundamentals are driven by unobserved (to the econometrician) permanent and transitory components, then the theoretical restrictions of a standard Present Value model of the current account might not be testable with a VAR. This is because the theoretical moving average representation can turn out to be noninvertible. This implies that observed data, including the current account, do not reveal the underlying shocks to agents' information sets. ; These results are potentially relevant given the results of several recent papers which claim that current accounts are 'excessively volatile'. I provide a simple example in which a researcher employing the Campbell-Shiller methodology is tricked into thinking the current account responds excessively to shocks when in fact the data are consistent with the theory.
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  • Kasa, Kenneth, 2003. "Testing present value models of the current account: a cautionary note," Journal of International Money and Finance, Elsevier, vol. 22(4), pages 557-569, August.
  • Handle: RePEc:eee:jimfin:v:22:y:2003:i:4:p:557-569
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    1. Glick, Reuven & Rogoff, Kenneth, 1995. "Global versus country-specific productivity shocks and the current account," Journal of Monetary Economics, Elsevier, vol. 35(1), pages 159-192, February.
    2. Campbell, John Y, 1987. "Does Saving Anticipate Declining Labor Income? An Alternative Test of the Permanent Income Hypothesis," Econometrica, Econometric Society, vol. 55(6), pages 1249-1273, November.
    3. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-987, December.
    4. Quah, Danny, 1992. "The Relative Importance of Permanent and Transitory Components: Identification and Some Theoretical Bounds," Econometrica, Econometric Society, vol. 60(1), pages 107-118, January.
    5. Otto, Glenn, 1992. "Testing a present-value model of the current account: Evidence from US and Canadian time series," Journal of International Money and Finance, Elsevier, vol. 11(5), pages 414-430, October.
    6. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-1088, October.
    7. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "The intertemporal approach to the current account," Handbook of International Economics,in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 34, pages 1731-1799 Elsevier.
    8. Sheffrin, Steven M. & Woo, Wing Thye, 1990. "Present value tests of an intertemporal model of the current account," Journal of International Economics, Elsevier, vol. 29(3-4), pages 237-253, November.
    9. Ahmed, Shaghil, 1986. "Temporary and permanent government spending in an open economy: Some evidence for the United Kingdom," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 197-224, March.
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    Cited by:

    1. Karunaratne, Neil Dias, 2010. "The sustainability of Australia's current account deficits--A reappraisal after the global financial crisis," Journal of Policy Modeling, Elsevier, vol. 32(1), pages 81-97, January.
    2. Elif C. Arbatli, 2008. "Futures Markets, Oil Prices and the Intertemporal Approach to the Current Account," Staff Working Papers 08-48, Bank of Canada.
    3. John C. Bluedorn, 2005. "Hurricanes: Intertemporal Trade and Capital Shocks," Economics Series Working Papers 241, University of Oxford, Department of Economics.

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