Robustness, Information-Processing Constraints, and the Current Account in Small Open Economies

51 Pages Posted: 19 Jul 2010

See all articles by Yulei Luo

Yulei Luo

University of Hong Kong

Jun Nie

Federal Reserve Bank of Kansas City

Eric R. Young

University of Virginia

Date Written: April 10, 2010

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

Luo, Yulei and Nie, Jun and Young, Eric R., Robustness, Information-Processing Constraints, and the Current Account in Small Open Economies (April 10, 2010). Available at SSRN: https://ssrn.com/abstract=1645057 or http://dx.doi.org/10.2139/ssrn.1645057

Yulei Luo (Contact Author)

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

Jun Nie

Federal Reserve Bank of Kansas City ( email )

1 Memorial Drive
Kansas City, MO 64198
United States
(816) 881-2255 (Phone)
(816) 881-2199 (Fax)

HOME PAGE: http://homepages.nyu.edu/~jn461/research.htm

Eric R. Young

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

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