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Habit Formation and the Present-Value Model of the Current Account: Yet Another Suspect

  • Takashi Kano

    (University of Tokyo)

A recent paper claims that habit formation in consumption plays an important role in current account fluctuations in selected developed countries, extending the present-value model of the current account (PVM) with consumption habits. In this paper, however, I show that the habit-forming PVM is observationally equivalent to the PVM augmented with persistent transitory consumption, which is induced by world real interest rate shocks. Based on a small open-economy real business cycle (SOE-RBC) model endowed with consumption habits as well as persistent world real interest rate shocks, this paper resolves the inherent identification problem of the habit-forming PVM by Bayesian methods to seek effects of habit formation on current account fluctuations in typical small open economies, Canada and the United Kingdom. Results reveal no clear evidence that habit formation plays a crucial role in current account fluctuations.

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Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-572.

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Length: 36 pages
Date of creation: Jun 2008
Date of revision:
Handle: RePEc:tky:fseres:2008cf572
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