A Structural VAR Approach to the Intertemporal Model of the Current Account

Abstract

The intertemporal current account approach predicts that the current account of a small open economy is independent of global shocks, and that responses of the current account to country-specific shocks depend on the persistence of the shocks. This paper shows that these predictions impose cross-equation restrictions (CERs) on a structural vector autoregression (SVAR). To test the CERs, this paper develops identification schemes of the SVAR that exploit the orthogonality of the world real interest rate and country-specific shocks as well as the lack of a long-run response of net output to transitory shocks. Tests of the SVAR reveal two puzzling aspects of the Canadian and U.K. current account: (i) the response of the current account to a country-specific transitory shock is too large and (ii) the fluctuations in the current account are dominated by country-specific transitory shocks that explain almost none of the fluctuations in net output growth. These results imply the crucial role of consumption-tilting factors in explaining current account fluctuations of the two economies.

Keywords: Current account, Small open economy, Present value model, World real interest rate, Structural VAR

JEL Classification: F32, F41