Academic journal article Journal of Money, Credit & Banking

Investment and the Current Account in the Short Run and the Long Run

Academic journal article Journal of Money, Credit & Banking

Investment and the Current Account in the Short Run and the Long Run

Article excerpt

SINCE THE OIL PRICE SHOCKS of the 1970s, attempts to explain the seemingly aberrant behavior of investment and the current account in the Group of Seven (G-7) economies have driven economists to distraction. To explain this behavior, the literature emphasizes the responses of investment and the current account to a variety of shocks given different technology, utility, asset market, and informational structures. Often, the literature judges the success of these explanations within the framework of the intertemporal, small open economy model. (1)

The implication of the intertemporal approach most tested in the literature is that the current account responds differently to temporary versus permanent domestic shocks. The current account reflects movements in output, investment, or government spending away from their expected permanent levels. Temporary shocks to these variables should affect the current account and permanent shocks should not, because consumers will attempt to smooth consumption in the face of temporary shocks by borrowing from or lending to the rest of the world, while permanent shocks cannot be smoothed away. As noted by Obstfeld and Rogoff (1995), this implication comes from assuming a small open economy, that interest rates are constant, and that shocks are country-specific. If the country is large, then shocks to income will also affect interest rates. In this case, the basic prediction that the current account should respond more to transitory than to permanent shocks will continue to be true. On the other hand, if the shock is global the intertemporal approach predicts that there should be little or no effect on the current account, even if the shock is perceived to be temporary. A temporary global shock will cause consumers in all countries to wish to borrow (or lend) so that interest rates should rise with little or no capital flows between countries.

Glick and Rogoff (1995) empirically examine several implications of the intertemporal model. Glick and Rogoff report a correlation between the change in the current account and the change in investment of -0.39 for the G-7 during the post-1975 period. At first glance, this correlation is puzzling in light of what appears to be open capital markets, which would suggest a correlation of -1.00. (2) To explain this puzzle, Glick and Rogoff argue that if variation in the world technology shock is large, theory predicts that the correlation of investment and the current account is larger than negative one (that is, closer to zero)--even with perfect capital mobility. They find that the current account does in fact appear to respond more to country-specific technology shocks (as measured by Solow residuals) than global shocks. They also find little response to either country-specific or global government spending shocks. Thus, Glick and Rogoff's calculations suggest that variation in the world technology shock is indeed large, accounting for nearly one-half of the variation in total productivity in the typical G-7 economy. (3)

Glick and Rogoff go on to uncover a new puzzle. According to the intertemporal model, a permanent country-specific productivity shock has a larger effect on the current account than on investment. Since permanent income rises above current income following the shock, domestic saving falls, and the current account (equal to domestic saving less investment) falls by more than investment rises. However, Glick and Rogoff find that country-specific technology shocks affect investment by two or three times more than they affect the current account. The authors offer a resolution to this puzzle by arguing that the country-specific technology shock follows a near random walk rather than a random walk.

In this paper, we examine the joint dynamic behavior of investment and the current account, in order to empirically evaluate the intertemporal, small open economy model. …

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