The Dynamic-Optimizing Approach to the Current Account: Theory and Evidence

The past decade has witnessed the development of a large theoretical literature on the intertemporal approach to the current account. These models typically emphasized the effects on the current account balance of real factors such as productivity, terms of trade, government spending and taxes via intertemporal substitution in consumption, production and investment. Could this micro based theory in any meaningful sense be wrong? The answer lies in the efforts to derive its empirical implications. Essentially the test of this theory is in proving the empirical importance of the role played by the intertemporal substitution. While this paper does not engage in formal statistical testing of the theory, the numbers it presents and the analysis of them shed light on the validity of the key testable hypotheses. The paper models investment and consumption (saving) in ways that emphasize intertemporal optimization and the differing effects of various shocks. Four different sorts of shocks are treated distincly: transitory or persistent in duration, and common or idiosyncratic across countries. Incorporating these considerations, the paper brings out a body of evidence in support of the key propositions of the dynamic-optimizing approach.