Recent years have witnessed the development of numerous theoretical models of an intertemporal approach to the current account, which emphasizes the effects of real factors such as productivity, the terms of trade, government spending and taxes. In Discussion Paper No. 797, Research Fellow Assaf Razin reviews the key propositions of this approach, which considers an intertemporal budget constraint and optimizing behaviour by households and firms, and he seeks to identify its main empirical implications. Such models emphasize intertemporal parameters and the debt/income ratio rather than the effects of income changes on spending and money demand considered by static models.

Razin notes that their assumption of perfect capital mobility suggests that they should explain current account fluctuations among OECD countries better than those of LDCs. He also shows that a permanent, country-specific shock will raise productivity and worsen the current account by raising investment and causing current consumption spending to rise in excess of current output; the current account will thus display a negative correlation with such shocks. In contrast, a transitory, country-specific shock will elicit a weaker investment response; current consumption will rise by less than current output, which yields a positive correlation. A global shock of either type will also raise the world interest rate, which dampens any rise in current consumption and investment spending, so the current account response will be smaller in either case.

Razin draws on data for 130 countries for 1950-88 to show that business cycle shocks are typically persistent and common to many countries and also feature various other regularities: there are positive correlations between the trade balance and the terms of trade and between the persistence of output and terms-of-trade shocks, and the trade balance is more volatile than the terms of trade or output. He reviews the key results of the limited empirical literature to date and sets out an agenda for future research.

The Dynamic-Optimizing Approach to the Current Account: Theory and Evidence
Assaf Razin

Discussion Paper No. 797, July 1993 (IM)