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

52 Pages Posted: 8 Jan 2011

See all articles by Jun Nie

Jun Nie

Federal Reserve Bank of Kansas City

Eric R. Young

University of Virginia

Yulei Luo

University of Hong Kong

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

Nie, Jun and Young, Eric R. and Luo, Yulei, Robustness, Infomation-Processing Constraints, and the Current Account in Small Open Economies (January 6, 2011). Available at SSRN: https://ssrn.com/abstract=1736145 or http://dx.doi.org/10.2139/ssrn.1736145

Jun Nie (Contact Author)

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

Yulei Luo

University of Hong Kong ( email )

Pokfulam Road
Hong Kong, HK
China

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