Interest Rates, Exchange Rates and Present Value Models of the Current Account

This paper develops a testable intertemporal model of the current account that allows for variable interest rates and exchange rates. These additional variables are channels through which external shocks may in¯uence the domestic current account. The restrictions from the theoretical model are subjected to present value tests using quarterly data from three small open economies. The paper ®nds that including the interest rate and exchange rate improves the ®t of the intertemporal model over what was found in previous studies. The model predictions better replicate the volatility of current account data and better explain historical episodes of current account imbalance. In theoretical research dealing with the current account, it has become standard practice to use intertemporal models. The intertemporal approach to the current account, in its simplest form, focuses on the optimal saving decision of a representative household as it smooths consumption. For example, considering a small open economy experiencing a temporary fall in output, the country would be expected to smooth consumption by borrowing in world capital markets and thereby run a current account de®cit. This basic intertemporal model has been extended in many directions in the theoretical literature, to include investment, variable interest rates, nontraded goods, and even monetary policy. 1 Empirical work on the intertemporal approach to the current account has lagged behind the theoretical literature. Simple intertemporal models focusing on consumption smoothing have been tested empirically in Sheffrin and