Robustness, Infomation-Processing Constraints, and the Current Account in Small Open Economies
52 Pages Posted: 8 Jan 2011
Date Written: January 6, 2011
Abstract
We examine the effects of two types of informational frictions, robustness (RB) and finite information-processing capacity (called rational inattention or RI) on the current account, in an otherwise standard intertemporal current account (ICA) model. We show that the interaction of RB and RI has the potential to improve the model’s predictions on the joint dynamics of the current account and income: (i) the contemporaneous correlation between the current account and income, (ii) the volatility and persistence of the current account in small open emerging and developed economies. In addition, we show that the two informational frictions could also better explain consumption dynamics in small open economies: the impulse responses of consumption to income shocks and the relative volatility of consumption growth to income growth. Calibrated versions using detection probabilities fit the data better along these dimensions than the standard model does.
Keywords: Robustness, Rational Inattention, Consumption Smoothing, Current Account, Detection Error, Probabilities
JEL Classification: C61, D81, E21
Suggested Citation: Suggested Citation
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