Obstfeld Rogoff Inter Temporal

Chapter 34
THE I NTERTEMPORAL APPROACH TO THE

CURRENT ACCOUNT
MAURICE OBSTFELD
University of California, Berkeley
and
KENNETH ROGOFF*
Princeton University
Cont ent s
1. I nt r oduct i on
2. The cur r ent account : Basi c concept s and hi st ori cal over vi ew
3. I nt e r t e mpor a l appr oaches t o t he cur r ent account
3.1. Deterministic models of the current account
3.2, Stochastic models of the current account
4. Empi r i cal evi dence on t he i nt er t empor al appr oach
4.1. The relationship between national saving and domestic investment rates
4.2. Tests of intertemporal current-account models
5. How usef ul is t he t heor y?
Ref er ences
1732
1733
1742
1743
1764.
1770
1776
1780
1792
1795
*We thank Geun Mee Ahn, Harald Hau, Matthew Jones, Giovanni Olivei, and Clara Wang for
excellent research assistance and the National Science Foundation, the German Marshall Fund of
the United States, and the Ford Foundation for financial support. Helpful suggestions were made
by David Backus, Richard Clarida, Jon Faust, Kiminori Matsuyama, Cedric Tille, and participants
in the March 1994 conference for the Handbook at Princeton University.
Handbook of International Economics, vol. IIl, Edited by G. Grossman and K. Rogoff
Elsevier Science B.V., 1995
1731
1. Introducti on
The i nt ert emporal approach views the current -account bal ance as the out come
of forward-l ooki ng dynami c saving and i nvest ment decisions. Int ert emporal
analyses of the current account became common in the earl y 1980s as a re-
sult of papers by Bui t er (1981), Obstfeld (1982), Sachs (1981), Svensson and
Razin (1983), and many others, although the approach had explicit precursors
in work on t rade and growth by Bardhan (1967), Bruno (1970), and Hamada
(1969). 1 As usual, this new focus in open-economy macroeconomi cs resul t ed
bot h from t heoret i cal advances in ot her parts of economi cs and from eco-
nomi c events that existing open-economy models seemed ill equi pped to ex-
amine.
Lucas' s (1976) influential critique of economet ri c policy eval uat i on was one
i mport ant theoretical mot i vat i on for an i nt ert emporal approach. His insistence
on grounding policy analysis in the actual forward-l ooki ng decision rules of
economi c agents suggested that open- economy models might yield mor e reli-
able policy conclusions if demand and supply functions were deri ved from the
opt i mi zat i on probl ems of households and firms rat her t han specified to mat ch
reduced-form estimates based on ad hoc economet ri c specifications.
Furt her impetus to devel op an i nt ert emporal approach came from events in
the worl d capital market , especially the substantial current -account imbalances
that fol l owed the sharp world oil-price increases of 1973-74 and 1979-80. The
di vergent pat t erns of current -account adjustment by industrialized and devel-
oping countries raised the i nherent l y i nt ert emporal pr obl em of characterizing
the opt i mal dynami c response to external shocks. Nei t her the classical monet ar y
models nor the Keynesi an models in vogue at the t i me offered reliable guidance
on this question. Similarly, the explosion in recycled bank lending to devel opi ng
countries aft er the first oil shock sparked fears that borrowers' ext ernal debt lev-
els might become unsustainable. The need to eval uat e devel opi ng-count ry debt
levels again led nat ural l y to the not i on of an i nt ert emporal l y optimal current-
account deficit.
This chapt er surveys the t heory and empirical work on the i nt ert emporal
approach to the current account as it has devel oped since the early 1980s. 2 Re-
cently, some researchers have studied dynami c stochastic i nt ernat i onal models
with compl et e Ar r ow- Debr eu forward market s for uncert ai n consumption. This
particular offshoot of the i nt ert emporal approach is the "compl et e-market s"
1A number of studies published in the early 1980s based exchange-rate or baLance-of-payments
models on intertemporal foundations. These contributions are surveyed in the chapter by Maurice
Obstfeld and Alan C. Stockman in volume 2 of this Handbook (Obsffeld and Stockman 1985).
2For a complementary survey, see Razin (t995).
1732
Ch. 34: The Intertemporal Approach to the Current Account 1733
model . Because compl et e- mar ket s model s fit mor e nat ur al l y i nt o Mar i anne
Baxt er ' s chapt er in this Ha ndbook, t hey are summar i zed onl y bri efl y here. We
r eser ve t he t er m " i nt er t empor al appr oach" - as well as t he bul k of our discus-
sion - f or model s wi t h i nt er nat i onal bor r owi ng and l endi ng but not necessari l y
wi t h compl et e i nt er nat i onal mar ket s in st at e- cont i ngent claims.
The chapt er begi ns wi t h an i nt r oduct or y sect i on, Sect i on 2, t hat expl or es the
concept of t he cur r ent account , its behavi or in r ecent history, and t he concep-
t ual adequacy of measur es of t he cur r ent account as r e por t e d by gove r nmc m
agencies.
Sect i on 3 lays out basi c i nt er t empor al model s of t he cur r ent account , star1
ing wi t h t he det er mi ni st i c case and t hen expl or i ng st ochast i c model s. Sect i on 4
shows how st ochast i c model s can be used to devi se t est s of t he i nt er t empor ai
appr oach, and goes on t o eval uat e t he resul t i ng evi dence.
Much of t he discussion t hr ough Sect i on 4 of this chapt er focuses on posiziv~ ~
pr edi ct i ons of t he i nt er t empor al appr oach. A maj or advant age of t he appr oach,
however , is its r el evance t o nor mat i v e quest i ons. Sect i on 5 t her ef or e t akes u I,
t he r easons why an i nt er t er mpor al appr oach t o t he cur r ent account is essent i al
f or sound pol i cy f or mul at i on.
Finally, we not e t hat , gi ven t he ext ensi ve r ecent l i t er at ur e this chapt er aspires
t o encompass, t her e are several i nst ances wher e space per mi t s us onl y to sket ch
al gebr ai c deri vat i ons. We t r y t o al er t t he r eader whe ne ve r i nt er medi at e al gebr a
has be e n pr uned especi al l y severel y, so t hat he or she will not become bogged
down dur i ng a first readi ng. Space limits l i kewi se al l ow us t o pr ovi de onl y an
i l l ust rat i ve r at her t han an exhaust i ve set of r ef er ences.
2. T h e c ur r e nt a c c o u n t : Ba s i c c o n c e p t s a n d hi s t o r i c a l o v e r v i e w
A count r y' s cur r ent - account bal ance over any t i me per i od is t he i ncrease in
r esi dent s' claims on f or ei gn i ncomes or out put s, less t he i ncrease in similar
f or ei gn- owned cl ai ms on home i ncome or out put . Thus, in t heory, t he cur r ent
account i ncl udes not onl y expor t s less i mpor t s ( br oadl y def i ned t o i ncl ude all
t he i ncome on and payout s on cr oss- bor der assets: di vi dends, i nt er est payment s,
i nsur ance pr emi a and payment s, etc.), but also net capi t al gains on existing
f or ei gn assets. Fr om t he close of Wor l d War I unt i l r el at i vel y recent l y, most
count r i es' hol di ngs of f or ei gn assets had been l i mi t ed bot h in quant i t y and scope,
so t he l at t er consi der at i on was secondary. A focus on t he cur r ent account as the
net expor t bal ance l ed some economi c t hi nker s t o vi ew r el at i ve i nt er nat i onal
pri ces as its cent r al det er mi nant . Thus was bor n t he "el ast i ci t i es appr oach" to
t he cur r ent account , under whi ch t he det er mi nant s of i nt er nat i onal expendi t ur e
l evel s and i ncomes are hel d fixed in t he backgr ound whi l e st at i c pri ce elasticities
of de ma nd and suppl y det er mi ne t he net i nt er nat i onal flow of capital.
1734 M. Obstfeld and K. Rogoff
As undergraduate macroeconomics texts demonstrate, however, the current
account also is national saving less domestic investment. If saving falls short of
desired investment, for example, foreigners must take up the balance, acquiring
as a result claims on domestic income or output. This alternative viewpoint,
which led to the absorption approach, stresses how macroeconomic factors must
ultimately determine international borrowing or lending patterns [Alexander
(1952)].
The intertemporal approach to current-account analysis extends the absorp-
tion approach through its recognition that private saving and investment deci-
sions, and sometimes even government decisions, result from forward-looking
calculations based on expectations of future productivity growth, government
spending demands, real interest rates, and so on. The intertemporal approach
achieves a synthesis of the absorption and elasticities view, however, by account-
ing for the macroeconomic determinants of relative prices and by analyzing the
impact of current and future prices on saving and investment.
International capital flows, in the form of trade credits and commercial traffic
in such assets as jewels and precious metals, were already common by biblical
times. By the early fourteenth century, Italian banks spanning western Europe
and the Levant had become large-scale lenders to sovereigns such as King Ed-
ward III of England, whose invasion of France in 1340, aided by foreign finance,
initiated the Hundred Years War. The two most powerful Florentine banking
houses, those of the Bardi and the Peruzzi, were bankrupted along with many
lesser banks in 1343 when Edward proved unable to meet his obligations. But
as Europe recovered from this early banking crisis and from the subsequent
Black Death (1348), international financial linkages grew strong once again.
The Catholic church, through its usury doctrine, unwittingly promoted the in-
ternationalization of banking in this period. While domestic loans for interest
were prohibited, there was no definitive ban on exchanges of bills payable in
different countries and currencies, even when the terms negotiated included im-
plicit interest charges [de Roover (1966)]. Theological constraints thus led the
largest banks to maintain extensive systems of foreign branches.
The expulsion of the Jews from the Iberian peninsula at the end of the fif-
teenth century, followed by widespread and continuing persecutions of Protes-
tants after the Reformation, created networks of refugee communities with
both the motivation and connections to move capital between countries. Dur-
ing European wars of the seventeenth and eighteenth centuries, international
capital markets developed further as some governments turned to large-scale
debt sales to foreigners. [See Neal (1990).] By the early nineteenth century at
the latest, the outlines of modern international capital markets are visible in
investors' search for profit opportunities on distant shores.
The era of the classical international gold standard, spanning the late nine-
teenth and early twentieth centuries, is often held up as a benchmark case
Ch. 34: The Intertemporat Approach to the Current Account 1735
of unf et t er ed capi t al mobi l i t y bet ween nations. Fi gur e 2.1 shows dat a on sav-
ing, i nvest ment , and t hei r di f f er ence, t he cur r ent account , f or a dozen coun-
tries over 1885-1913. (All dat a ar e nomi nal flows di vi ded by a nomi nal in-
come or out put measur e. ) 3 The graphs i ndeed show sever al exampl es of l arge
and pr ot r act ed cur r ent - account i mbal ances, i ndi cat ors of ext ensi ve t r ade across
t i me. Canada r an per si st ent deficits which, by t he eve of Wor l d War I, ex-
ceeded 15 per cent of gross nat i onal pr oduct ( GNP) . Thes e l arge flows wer e
undoubt edl y p r o mo t e d by Canada' s close pol i t i cal and cul t ural links wi t h t he
Uni t e d Ki ngdom, t he l argest l ender. But even count r i es wi t hout such close
ties t o pot ent i al l ender s wer e abl e t o dr aw ext ensi vel y on i nt er nat i onal cap-
ital mar ket s. J apan r an an ext er nal deficit of 10 per cent of nat i onal expen-
di t ur e in financing its 1904-1905 war with Russia. Dur i ng Wor l d War I, t he
count r y r an a compar abl e surplus t o hel p fi nance its fi nanci al l y bel eagur ed
allies. 4
Da t a f r om t he i nt er war per i od, shown in Fi gur e 2.2, r eveal a part i al r esur gence
of net i nt er nat i onal bor r owi ng and l endi ng as post war r econst r uct i on progresses,
but this process comes t o a sudden hal t as rest ri ct i ons on i nt er nat i onal payment s
pr ol i f er at e af t er t he onset of t he Gr e a t Depr essi on. s Post -1945 dat a disclose a
r ever se evol ut i on. Initially, cur r ent - account i mbal ances wer e slight because or
official rest ri ct i ons on i nt er nat i onal capi t al movement s , wi t h most i ndust ri al -
count r y cur r enci es bei ng i nconver t i bl e t hr ough 1959. Af t e r t he ear l y 1970s (see
Fi gur e 2.3), net i nt er nat i onal capi t al flows expanded as a resul t of pet r odol l ar
recycl i ng, t he r emoval of many i ndust r i al - count r y rest ri ct i ons on i nt er nat i onal
payment s fol l owi ng t he adopt i on of fl oat i ng exchange rat es, and t echnol ogi cal
evol ut i on in t he fi nanci al industry. By t he 1980s, t he l argest i ndust ri al count ri es,
Ger many, Japan, and t he Uni t ed States, wer e showi ng subst ant i al ext er nal im-
bal ances. At t he same t i me ma ny devel opi ng count ri es, caught in a debt crisis
br ought on in par t by vi gor ous bor r owi ng in t he 1970s, f ound t hemsel ves de-
ni ed access to r esour ce inflows. Onl y in t he ear l y 1990s di d this st ark bor r owi ng
const r ai nt begi n t o ease.
Unf or t unat el y, t he saving and i nvest ment flows r epor t ed in nat i onal i ncome
and pr oduct account s (NIPA) and shown in Fi gures 2.1 t hr ough 2.3 don' t always
conf or m cl osel y t o t heor et i cal l y cor r ect concept s of saving and i nvest ment , par-
t i cul arl y when i nt er nat i onal capi t al mobi l i t y is ext ensi ve. One especi al l y seri ous
def ect is t he f ai l ur e of NI PA nat i onal i ncome measur es ful l y t o refl ect capi t al
gai ns and losses on net f or ei gn assets. Dur i ng 1991, f or exampl e, t he NI PA mea-
3These data, as well as those shown in Figure 2.2 below, are from Jones and Obstfeld (1994).
Finland was actually a possession of Russia during the 1885-1913 period, but it was afforded a fair
amount of administrative autonomy.
4For a discussion of wars and the Japanese current account during the first part of the twentieth
century, see Obstfeld and Rogoff (1996), ch. 1.
5See Eichengreen (1990) for further discussion.
1736
0.4
Australia
0.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
El
~0. 2 ~
: 0.1
.g
-0.1 2 3 ~ ~ ...................................... .....................................................
-0,2 I l l l : l : ; l l l l [ l l ; ; : l ( l : l l l ; l l
188 1892 1899 1906 191:
0. 4
M. ObstJeld and K. Rogoff
Finland
0,3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
El
0.2
' 6
= 0,1
O
u- -0.1 ..................... : : Z: ~ .................... "~-" ~ . ~
-0.2 I I I I t I I i i i i i i i i i i i , L~- +- I i i t ~
1885 1892 1899 1906 191
0,4
Sweden
0.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o.
3
(~ 0. 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
= 0.1
0
-0.2 +-/-/--I I I I I ', ', ', ', ; ', ', ; ; ; ; I I t I t I I 111913
1888 1892 1899 1906
0. 4
Norway
0.3
O.
Z
(9 0.2
"6
c 0.1
,0.
29
U'.o. 1
-0" 8 i 1892 1899 1906 191
0.4
Denmark
0.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
El
' 6 (~ 0. 2
0.1
o
0 , >.
" -0.1 .............................................................................................................................
!
" 0. 2 ', ', ', : ', ', ', ', L ~ I i I I I I t I I ~ I I ++- ~- ~- I - ~- ~
1885 1892 1899 1906 1913
0. 4
Italy
0. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
~0.2
c 0.1
2 ~ l l : : ~ l ; : l ; ; ; ; l l l t l E I I l i t i l l
~' 1885 1892 1899 1908 1913
- I nvest ment - Savi ng - - Cur r ent Account
Figure 2.1. Saving, investment, and the current account: Classical gold standard, 1885-1913.
Ch. 34: The l nt ert emporal Appr oac h to the Current Ac c ount
1737
United States
0,4
~. 0. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Z
0. 2 ...................................................................
c 0.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o
u. - 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1885 1892 1899 1906 1913
United Kingdom
0. 4 . . . .
O. 0, 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
t : 3
(=9 0. 2
= 9. 1
~ 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
u--0.1 ......................................
1885 1892 1899 1906 1913
0.4
Canada
z m 0. 3
0 0, 2
c 0. 1 ................................................................................
. 9
0 .. . . .. ... .. ... .. ... ... .. ... .. ... ... .. ... .. ... ... .. ... .. ... ... .. ... ... . .. . .. . . .. .
- 0. 1 ............ ~- ~ . . . . . . . . . . . . . . . . . . . . . ~'
\ /
1885 1892 1899 1906 1913
France
0, 4
O~ 0, 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C~
0 0. 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c 0.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
, o
0 ,~ ~ ~, ~- ~ ~. ,
" _0, 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0, 2 i i i i t=-i r i i i i i [ f--. +-; ; 'r ; : ; ; ; I I I
1885 1892 1899 1906 1913
0.4
Germany
0. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
z
z 0, 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
e 0. 1
0
0 2 ~ ~ " ~ ~ ' " ~ - ~ ' 2 Z " > ~ ' ~ : ~ . ~ - ~ ' . ~ - ' ~
u. . - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
0. 2 I ~ I ~ '~ : I ; : : ', : ; i i { ~ i i I -~F=t =~- i i i i L
1885 1892 1899 1906 1913
Japan
0. 4 . . . . . . . . . . . .
0, 3
ILl
Z
O 0, 2
c 0. 1
, o
u. - 0. 1
. . . . . . . . . . . . " - ~ . . . . . . . . . . . . . . . . . . ! ~, ! . . . . . . . . . . . . . . . . . . . . . . .
- 0. 2 ~- ~- i f ' , : ', : ; ; ; ; ; ; ; ; i i r ~ i i ~ [ J i
1885 1892 1899 1906 1913
- - I nvest ment - - Savi ng
Fi gur e 2, 1, continued.
Cur r ent Account
1 7 3 8
0. 4
Australia
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o ,
= 0 . 1
0
0 .... . . . . . . . . . . . . . . . . . . . . . . . . . , - ' ~ ~ - " , , ; ~ . ~ ........
u . . 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . >',~ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 . 2 i r i ~ L i i i i i ~ i i i ~ i i
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
0, 4
M. Obs t f e l d and K. Rogof f
Finland
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o 0 2
c 0 . 1
9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -
- 0 . 1
- 0 , 2 l l q ~ l l l l l ~ l l l l l i l l
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
Sweden
0. 4
e. 0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . .
o
O 0 . 2
= 0 . 1 ..............................................................................
. o
a. -0.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 . 2 i i i i i i i i i i i i i r i i i - i - - +
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
Norway
0 . 4
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
0 . 2
c 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o
u. -0.1 .................................................................................
- 0 . 2 - - ~ - , - - , - - , - - - - ~ t - . f - - f - - ~ - - f - = . f - - t ~ f - - - i i i i
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
Denmark
0. 4
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o .
c3
O 0 , 2 . . . . . . . . . . . . . . . . . . . . . . .
"6
= 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. o
" - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 . 2 i + ~ ~ ~ ~ , , ~ , ~- ~- - +- +- - ~+ ,
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
0. 4
Italy
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a .
z
= 0,1
._o
u . - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 . 2 I I I I I I I I I I I I I I l I I I I
1 9 2 1 1 9 2 7 1 9 3 3 1 9 3 9
- - I n v e s t me n t - - S a v i n g - - Cu r r e n t Ac c o u n t
F i g u r e 2 . 2 . S a v i n g , i n v e s t m e n t , a n d t h e c u r r e n t a c c o u n t : I n t e r - w a r e r a , 1 9 2 1 - 1 9 3 9 .
Ch. 34: The lntertemporal Approach to the Current Account
I 739
0.4
United States
0. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
z
0. 2 . . . . . . . . . . . . . . . . . . . . . . . .
c 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
0
' "-0. 1 " . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0' 219LI j 2 + ~- ~- * ~ E i b i ~ - ~ ~
1927 1933 1939
0. 4
0.3
Q.
E3
(3 0. 2
`6
.~ o.1
a . 4) . 1
- 0. 2
1921
United Kingdom
1
J
. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . i
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I
J
1927 1933 ! 939
Canada
0,4
0. 3 ..........................................................................................
o.
z
L~ 0. 2
c 0. 1
.9
" - 0, 1 ..................................................................................................................
- 0, 2 ~- I p i i ] =l I I I I P q I I I I I I
1921 1927 1933 1939
Germany
0, 4
0. 3
el.
z
Z 0.2
`6
e o. 1
o
~ o
u. -17.1
- 0' 219~1
1927 1933 1939
0.4
Japan
z.u 0. 3 ....................
Z
(3 0. 2
= 0.1 .............................................................................................................
0
o
u. -0. 1 .......................................................................................
-0,2 ', ', = ; ', ; i i i r P i i ] I I l [ E
1921 1927 1933 1939
- I nvest ment - Savi ng
Fi gur e 2. 2. continued.
- Cur r ent Account
1 7 4 0
A u s t r a l i a
0. 4
0 ~ 0.20"3 ..................................................................... . ~
c 0.1 ...............................................................................
0
0 .~-- --.-.-~ ............................................................
u . - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 , 2 I i ~ i ) l - + - - - ) : - ~ t t - - ~ + - - ~ + - F - +
1973 1979 1985 1991
M . O b s t f e l d a n d K . R o g o ] "
F i n l a n d
0. 4
O EL 0. 3
0 0. 2
= 0.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. o
O . . . . . . . . . . . . . . . . . . . ~ . . . . . . . . . . . . . . . .
u . d ) . l ~ ' / ~
1973 1979 1985 1991
S w e d e n
0. 4
0.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
n

0 0 , 2
"6
= 0. 1 ................................................................................
0
O -- .w~,<-~-~.~. -.g~ 222 2, - ; ' ~- " ' ~ . . . . . ~ ~ ; ~
t u - 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 , 2 t I - F - - I I I I I I I I ) J r - - ~ - - ~
973 1979 1985 1991
0. 4
N o r w a y
0. 3
L
3
0 0. 2
"6
= 0.1
o
o
u. -0.1
- 0 . 2 ~ -
1973
~ . . / /
......... > , - . ~:.~;/ ............................................................
i P - I I I ~ - i I I ~ i I I I I I I
1979 1985 1991
D e n m a r k
0. 4
0.3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
E L
?, 0.2
= 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
= O
u . - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
- 0 , 2 + I I + - - ~ I I 1 i - - f - - 4 ~ t - - + - - k - - u ~ I I
1973 1979 1985 1991
0. 4
I t a l y
c~ EL 0. 3 i
O 0. 2
= 0 . 1 ...........................................................................
.2
0 ~ . . ~ 2 ~ - ~ - ~ . ~ g ; : ~ . z ~ - ~ - ~ - ~ - ~ - , - ~ ; .-
" - 0 . 1 .......................................................................................
- 0 . 2 - t I I I . t - ~ ; i ; ; ', l ; ; ; - I I t I I
1973 1979 1985 1991
- - I n v e s t m e n t - S a v i n g . C u r r e n t A c c o u n t
F i g u r e 2. 3. S a v i n g , i n v e s t me n t , a n d t h e c u r r e n t a c c o u n t : P o s t - B r e t t o n Wo o d s e r a , 1 9 7 3 - 1 9 9 1 .
Ch. 34: The Intertemporal Approach to the Current Account
1741
United States
0 . 4 0 . 4
0 , 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
r~ 0 . 2 . . . . . . . . . . . . . . . . . . . . . . . . . . .
, - 0 . 1 .........................................................................................................
. 2
~ " - 0 . 1 ..................................................................................................................
1 9 7 3 1 9 7 9 1 9 8 5 1 9 9 1
0 . 3
13,
( 9 0 . 2
c 0.1
o_
u. -0A
United Kingdom
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ,i
1 9 7 3 1 9 7 9 1 9 8 5 i ~ 9 ~
Canada
n 4
0 . 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
0 . 2
" 6
, - 0 . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
o
- + -
u . - 0. 1 ...............................................................................................
1 9 7 3 1 9 7 9 1 9 8 5 1 9 9 1
France
0 . 4
o . 0 . 3 . . . . . . . . . . . . . . . . .
( 9 0 , 2 . . . . . . . . . . . . . . . . . . - , . P ~
, - 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. 2
m- 0. 1 .............................................................................................
1 9 7 3 1 9 7 9 1 9 8 5 1 9 9 1
0 . 4
Germany
0 , 3 ...............................................................................................................
0 .
0 . 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
" 6
0. 1 ................................................................................................................
O
u. 4) . 1 ............................................................................................................ i
1 9 7 3 1 9 7 9 1 9 8 5 1 9 9 1
Japan
o. ,
0 . 3
0 . 2 ............................................................. L Z I I 7 ........................... 1
= 0. 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i
0
u" " 0. 1 .......................................................................... {
i
1 9 7 3 1 9 7 9 1 9 8 5 1 g)~,~
- i n v e s t m e n t - S a v i n g
Fi gur e 2. 5. col~[muea.
C u r r e n ~ A c c o ~
1742 M. ObstJeld and K. Rogoff
sur e of savi ng l ess i nves t ment for t he Uni t e d St at es, t he cur r ent account , was
r e por t e d by t he U. S. De p a r t me n t of Co mme r c e as - $ 3 . 7 billion. The De p a r t -
me n t of Co mme r c e also cal cul at ed, however , t hat on a ma r ke t - va l ue basi s, U. S.
asset s hel d a br oa d at t he end of 1990 appr eci at ed in dol l ar val ue by $67.8 bi l l i on
( mor e t han t he ent i r e 1991 pur chases of f or ei gn asset s by U.S. r esi dent s, $62.2
bi l l i on). At t he s a me t i me, t he dol l ar val ue of f or ei gn cl ai ms on t he U. S. at t he
end of 1990 r ose by $172.8 bi l l i on ( mor e t han 2.5 t i mes as l ar ge as t he 1991
f or ei gn pur chas es of U. S. assets, $67.0 bi l l i on). 6 I n economi c t er ms, t he t r ue
dol l ar U. S. cur r ent - account deficit f or 1991 is p r o b a b l y much cl oser t o - $3. 7
bi l l i on + $67.8 bi l l i on - $172.8 = - $108. 7 bi l l i on t han t o its si mpl e NI PA me a -
sure. And e ve n t hi s figure refl ect s onl y par t i al c ove r a ge of i nt er nat i onal asset
hol di ngs.
The numbe r s in Fi gures 2.1 t hr ough 2.3 ar e mi sl eadi ng f or a not he r r ea-
son. As Sect i on 3 shows, it is changes in real, not nomi nal , asset hol di ngs
t hat ma t t e r f or a count r y' s wel f ar e. Thus, NI PA me a s ur e s of t he cur r ent ac-
count , e ve n if cor r ect ed t o i ncl ude nomi nal capi t al gai ns and losses, mus t be
adj ust ed as wel l t o cor r ect f or t he i nf l at i onar y er os i on of f or ei gn asset s' r eal
val ues.
Thes e p r o b l e ms pl ague all of t he empi r i cal l i t er at ur e di scussed in Sect i on 4,
al t hough it woul d be possi bl e t o r e me d y t he m s ome wha t for a f ew i ndust r i al
count r i es. I n empi r i cal l y eval uat i ng t heor i es it is obvi ous l y cruci al t o achi eve t he
bes t possi bl e ma t c h be t we e n t he concept ual f r a me wo r k and t he dat a br ought
t o be a r in t est i ng it.
3. Intertemporal approaches to the current account
A r eal i st i c e c onomi c model i ncor por at i ng all e l e me nt s r el evant t o t he t ypi cal
count r y' s cur r ent account woul d be hopel essl y compl ex. I ns t ead of a t t e mpt i ng
t o const r uct such a compr ehens i ve model , we t ur n in this sect i on t o a succes-
si on of model s t hat i l l ust rat e what we bel i eve t o be t he ke y el ement s i nfl uenci ng
s a vi ng- i nve s t me nt bal ances in t he wor l d economy. I n f ol l owi ng this st rat egy, we
l ar gel y par al l el t he de ve l opme nt of t heor et i cal t hi nki ng on t he cur r ent account
ove r t he pas t fi ft een year s An i mpor t a nt set of i nsi ght s can be der i ved even
f r om det er mi ni s t i c model s; this is our first or der of busi ness. We t hen i nt r oduce
uncer t ai nt y about t he economi c e nvi r onme nt and deduce a n u mb e r of essen-
t i al modi f i cat i ons of t he pr ecedi ng nonst ochast i c f r a me wor k. The i nt r oduct i on
of uncer t ai nt y is, of course, a pr er equi s i t e f or t he empi r i cal anal ysi s of t he in-
t e r t e mp o r a l a ppr oa c h t hat we discuss in Sect i on 4.
6The United States capital-account surplus, equal to $67.0 billion - $62.2 billion = $4.8 billion,
differs from the recorded current-account deficit by a statistical discrepancy of -$1.1 billion.
Ch. 34: The Intertemporal Approach to the Current Account
3.1. Deterministic model s of the current account
! 743
The first br oad class of model s t o be descr i bed assumes t hat i ndi vi dual deci si on
maker s have per f ect f or esi ght and compl et e i nf or mat i on about t hei r economi c
envi r onment . Whi l e t hese model s lack real i sm al ong some di mensi ons, t hey
serve at l east t wo ver y useful purposes. First, t hey el uci dat e a numbe r of que:~
t i ons f or whi ch uncer t ai nt y is of secondar y i mpor t ance, and second, t hey pr ovi de
a be nc hma r k agai nst whi ch to meas ur e t he pr edi ct i ons of r i cher st ochast i c r ood
els. As we shall see later, st ochast i c model s in which real bonds arc t he oni v
assets count r i es t r ade i mpl y r esponses t o shocks similar t o t he i mpul se r esponses
of det er mi ni st i c model s.
3.1.1. A one-good model with representative national residents
Consi der a small open e c onomy t hat pr oduces and consumes a single c o mp o s
i t e good and t r ades f r eel y wi t h t he rest of t he world. Fr ee t r ade i ncl udes t he
i nt er nat i onal exchange of assets. We assume t hat t he onl y t r aded asset is a
cons umpt i on- i ndexed bond wi t h fixed face val ue t hat pays net i nt er est at t he
r at e rt bet ween per i ods t - 1 and t. I mpor t ant l y, l abor is i nt er nat i onal l y i mmo-
bile. In per capi t a t erms, l et At+l denot e t he economy' s st ock of net f or ei gn
claims at t he end of per i od t, Yt net domest i c pr oduct or out put in per i od r,
Ct pr i vat e consumpt i on, Gt gover nment consumpt i on, and It net investmem= ~
The n t he i dent i t y l i nki ng net f or ei gn asset a c c u mu l a t i o n - t hat is, t hc curlTelli
account , CA t - t o t he savi ng- i nvest ment bal ance is:
CAt =A t +l - A t = rtAt + Yt - Ct - Gt - Lt (3.1)
Def i ne t he ma r ke t di scount f act or f or dat e s cons umpt i on by
1
R , . , = r I = , + l ( 1 + ( 3 . 2 /
( wher e Rt,t = 1). For war d i t er at i on of eq. (3.1) l eads t o
o o
(1 + rt)At = Z Rt,,(C.,. + Gs + I~ - Ys) + l i m R,,sAs+l
S ~ + O O
S = t
Because f or ei gn l ender s will not al l ow t he e c onomy to rol l over a debt indel;o
i ni t el y t hr ough unl i mi t ed bor r owi ng, t he condi t i on lims-~oo Rt,sAs+l >~ 0 appl i cs
above. The resul t i ng intertemporal budget constraint f or t he economy is thus:
o o o o
~-'~ Rt,s(C,. + Gs +i s) < (1 + rt)At + Z Rt,sYs (3.3)
s=t s=t
In t he model s we sur vey no r esour ces are willingly f or gone, so (3.3) always hol ds
7We wi l l a s s u me f o r s i mp l i c i t y t h a t c a p i t a l d o e s n o t d e p r e c i a t e .
1744 M. Obstfeld and K. Rogof f
wi t h equality. In t hat case, (3.3) states t hat t he pr esent val ue of the economy' s
expendi t ur es must equal its initial net forei gn weal t h plus the present val ue of
domest i c product i on.
The i nt er t empor al budget const rai nt del i mi t s the feasi bl e choices of the econ-
omy. To descri be the circumstances in which current -account i mbal ances will
arise, however, one must specify how t he component s of expendi t ur e and out -
put are det er mi ned. We assume t hat the r epr esent at i ve consumer maxi mi zes t he
t i me- separ abl e funct i on
oo
ut = Z 'uICd I3.4)
s =t
wher e/ 3 c (0, 1), u' ( C) > O, u"( C) < O.
The st rong i nt er t empor al separabi l i t y of utility assumed in (3.4) will form t he
backbone of our formal analysis. Bef or e going furt her, it is wort hwhi l e to offer
some j ust i fi cat i on for this decision.
(1) One mi ght wish to start with a very general i nt er t empor al l y nonsepar a-
ble ut i l i t y f unct i on of t he f or m Ut = U( Ct , Ct+l, ...). But this woul d yi el d few
concret e and t est abl e behavi oral predictions. I nst ead we prefer to begi n wi t h
a t ract abl e basic set up like eq. (3.4) wi t h st rong implications. Preferences t hen
can be gener al i zed if t he basic setup seems to be l eadi ng us as t r ay/
(2) Aggr egat i on, across bot h goods and i ndi vi dual s, may cause i nt er t empo-
ral dependenci es appr oxi mat el y to cancel out at t he level of t ot al per capi t a
consumpt i on.
(3) At t he levels of t i me aggregat i on common in macr oeconomi c model s, t he
assumpt i on of i nt er t empor al separabi l i t y is not i mpl ausi bl e. In any event , while
empi ri cal research on dat a at these frequenci es has rai sed i nt erest i ng quest i ons
about the t i me-separabl e ut i l i t y model , it does not cl earl y poi nt to a superi or
nonsepar abl e al t ernat i ve.
Havi ng def ended our choice of i nt er t empor al l y addi t i ve ut i l i t y funct i ons, we
now begi n to pursue t hei r implications. Let lit be t he real val ue of domest i c
firms at t he end of peri od t - 1 (after peri od t - 1 di vi dends have been paid),
Bt t he st ock of i nt erest -earni ng claims owned by t he domest i c pri vat e sector at
t he end of t - 1, wt the real wage in peri od t, Lt t he per capita suppl y of labor,
and Tt l ump- sum taxes levied by the home gover nment . Then t he i nt er t empor al
budget const rai nt of t he represent at i ve consumer is 9
8pl ausi bl e non- t i me- s epar abl e al t er nat i ves t o (3.4) can be anal yzed; [see, for exampl e, De ve r e ux
and Shi (1991), Obs t f el d (1982), Shi and Eps t ei n (1993), and Svens s on and Razi n (1983)].
9Strictly speaki ng, t he way t he next const r ai nt is e xpr e s s e d as s umes per f ect f or esi ght b e t we e n
dat es t - 1 and t, so t hat a r at e of r et ur n of rt act ual l y is e a r ne d on s har es ex post . Thi s as s umpt i on
is ma de onl y t o avoi d cl ut t eri ng t he not at i on, and is not i mpos e d in what follows. A mor e gener al
f or mul at i on si mpl y woul d r epl ace (1 + rt)Vt by t he ex pos t val ue (inclusive of di vi dends) of s har es
bought on dat e t - 1.
O 0 0<3
~ R,,~c~ = (1 + r, ) ( vt + Bt ) + ~ Rt,s(wsLs - "tO C3.51
s=t s=t
When (3.4) is maximized subject to (3.5), consumption necessarily follows the
i nt ert emporal Eul er equat i on
u ' ( C t ) =/ 3( 1 + r t +l ) u ' ( Ct +l ) ~ c.',
This optimality condition, stressed long ago by Irving Fisher (1930), equate~
the marginal rate of substitution of present for future consumption, whM.. ;,
just / 3 u ' ( C t + l ) / u ' ( C t ) , to the price of future consumpt i on in terms of presem
consumption, 1/(1 + rt +l ) . An implication is that, leaving aside discrepancies
bet ween/ 3 and 1 / ( l + r t < ) , optimized consumption will follow a smoo!h, c,onst:ap.',
pat h (recall that u ( C ) is strictly concave). A convenient closed-form descripli,w_
of the current account is obt ai ned by specializing further to the case in whic!~
u ( C ) takes the isoelastic form
c 1-1/' ~ - 1
u(C) -
1 - 1/ o"
with o- > 0 the elasticity of intertemporal substitution, In this case (3.6 9 impiic,:
that optimal consumpt i on growth obeys
Ct+l =/ 3~( 1 + r t <) ' ~ Ct (3.7)
The consumpt i on pat h described above must satisfy the economy' s intertom
poral constraint; using (3.7) to eliminate Cs ( s > t ) from (3.3) shows 1hal lhe
economy' s dat e t consumpt i on will be:
Ct = ( 1 + r t ) At E s =t Rt , s ( Ys - Gs - I s) ( 3 . 8 )
oo R
E,=t , , , ( / 3 ~- ' I R , , ~) ~
Equat i on (3.8) leads to an illuminating general charact eri zat i onof the currcm
account. Define the "permanent " level of variable X on date t , X , , by
_ Es%t R,,,X~.
and define ( / 3 / R ) ~ as the following weighted average of ratios of (s -- 0- per i od
subjective and market discount factors raised to the power 0.:
x-,oo R { s - t / R ho-
( / 3 / R ) ~ = z..,s=t t , s v~ / t,s2
~o R
E , ' , ' = t t ~ s
Then, a f t e r m a n y s t e p s , eqs. (3.1) and (3.8) show the current account surplus on
1746 M . O b s t f e l d a n d K. R o g o f j :
dat e t to be:
C A t = ( r t - f t ) A t + ( l i t - L ) - ( G t - G t )
- ( / t - ~ ) + [1 1 ]
( At + B - - d t - i t ) ( 3 . 9 )
(As we al l uded in t he i nt r oduct i on, t her e are sever al places wher e we advi se
t he r eader t o consi der hol di ng of f on r epr oduci ng a r esul t until a l at er readi ng;
this is t he lirst.) Equat i on (3.9) yields a numbe r of i mpor t ant pr edi ct i ons ( each
of whi ch r equi r es a cet eri s par i bus clause): 1
(1) If t he e c onomy is a net f or ei gn cl ai mant and t he worl d i nt er est r at e is
above its pe r ma ne nt average, t hen t he cur r ent account will be in gr eat er surpl us
as peopl e s moot h cons umpt i on in t he face of t empor ar i l y high f or ei gn i nt er est
i ncome. If t he e c onomy is a net f or ei gn debt or, t empor ar i l y hi gh i nt er est r at es
will have an opposi t e cur r ent - account effect .
(2) Out put above its pe r ma ne nt l evel will cont r i but e t o a hi gher cur r ent -
account surplus, agai n due to cons umpt i on smoot hi ng. Similarly, t he pr i vat e
sect or will use f or ei gn bor r owi ng t o cushi on its cons umpt i on f r om abnor mal l y
hi gh gove r nme nt cons umpt i on and i nvest ment needs.
(3) The last t er m in (3.9) reflects cons umpt i on t i l t i n g due to di ver gences in t he
cur r ent and f ut ur e per i ods bet ween wor l d real i nt er est rat es and t he domest i c
r at e of t i me pr ef er ence, (1 - f l ) / f i . Whe n t he home count r y is on aver age mor e
i mpat i ent t han t he rest of t he worl d, fl is l ower t han f ut ur e wor l d i nt er est r at es
will t end t o be, resul t i ng in ( f l / R ) ~ < 1. The r e will t hen be a secul ar t endency
t owar d cur r ent - account deficits, and t hus t owar d secul arl y i ncreasi ng f or ei gn
debt and decl i ni ng consumpt i on. When it is f or ei gner s on t he ot her hand who
ar e ( on aver age) mor e i mpat i ent , so t hat ( f i / R ) ~ > 1, consumpt i on' s t i me pat h
will have an upwar d tilt. The tilting ef f ect is pr opor t i onal t o t he economy' s
" pe r ma ne nt " resources. Al so, t he tilting ef f ect is st r onger t he hi gher is t he case
of i nt er t empor al subst i t ut i on in consumpt i on, meas ur ed by o-.
iA less general version of eq. (3.9) is presented by Sachs (1982). To derive the first entry on the
right-hand side of (3.9), observe that
l +r t _ r t + 2 s T _ t + l R t , s r s _ ~ s ~ t R t , s r s Ft.
X2 R Oa O0
where we have made use of the fact that
oo
~ ' ~ R t , s r s = 1
s - - t +l
The rest is straightforward; for details, see Obstfeld and Rogoff (1996), ch. 2.
Ch. 34: The Int ert emporal Appr oach to the Current Account 1747
Before exploring the short-run implications of eq. (3.9), it is useful to consider
some of the model' s predictions for steady-state current-account behavior in a
growing economy. As we shall see, a growing economy can run a current-account
deficit indefinitely.
Incorporating the investment effects of growth forccs one to model explic-
itly the linkage bet ween capital accumulation and production. Assumc that the
product i on function for a small economy is Cobb-Dougl as:
g , = Ot K~ L 1-~
(c~ < 1), where Kt is the end of peri od t - 1 capital stock (available for production
in peri od t), L is the constant l abor force (which we will normalize to 1 for
convenience), and the productivity coefficient 0 grows so that
Or+ 1 = (1 + g ) l - c ~ o t
with g > 0. Assume also that the capital stock can adjust in a period, withoul
installation costs. In the absence of unanticipated shocks, the marginal product
of capital, a Ot K~ - 1 , thus must equal r, the constant world interest rate; r > g
by assumption. 11 Then, in a steady-state equilibrium, investment is easily shown
to be
( ~ ) 1/(1 c0 ( - ~ )
i t = Kt +l - Kt = g = Y t
Out put and investment t herefore bot h grow at rate g. If government spending
is zero, then one can use (3.9) to show that the optimal current account is given
by
C A t = A , + I - A t = - [ 1 ( l +r ) ~/ 3~] At - l + g - ( l + r ) ~ f i ~ (1 ~ ) Yt
r - g
Division by Y t yields a difference equation in A / Y ,
At+lYt+l = ( ( l + r ) ~ x j A t l 7 7 / Yt 1 + g - ( 1 + r ) ~ / 3 ~ - ~ - +gT~_- - ~ ( 1 - ~ )
Provi ded (1 + r ) " ~ < 1 +g, the st eady state is stable; it is the negative number
1 - ( a g / r ) (3.10)
A / Y - - ( r - g)
Notice that, because a g / r = I / Y , the long-run ratio of foreign debt to out put
equals the ratio to current out put of the e nt i r e p r e s e n t v a l u e of future out put
net of investment.
11For the world economy as a whole, the assumption that the growth rate does not exceed the
interest rate can be justified using the standard Cass-Koopmans general equilibrium growth model.
What size debt - out put rat i o does eq. (3.10) i mpl y? Suppose t he worl d real
i nt erest rat e r is 8 percent per year, g is 4 percent per year, and a = 0.4. Then
A / Y -- - 20, and the economy' s t rade bal ance surplus each peri od must be
- ( r - g ) A / Y = 80 percent of GDP!
Such l arge debt levels and debt burdens are never observed in practice:
economi es t hat must borrow at mar ket i nt erest rat es rarel y have debt s as great
as a single year' s GDR The anomal ous predi ct i on poi nt s to some short comi ngs
of t he model . Wi t h finite lifetimes, i ndi vi dual s cur r ent l y alive woul dn' t be abl e
t o bor r ow agai nst t he ent i re present val ue of t he economy' s out put . Ther e is no
al l owance in t he model for soverei gn risk. Finally, we not e t hat t he worl d inter-
est rat e r is det er mi ned by t he rest of the worl d' s growt h rate. In this exampl e,
however, t he worl d growt h rat e must equal (1 + r)~/3 ~ [see Obst fel d and Rogof f
(1996), ch. 2], which is less t han 1 + g by assumpt i on. But if a small economy
wer e to grow fast er t han t he worl d for a sufficiently l ong period, it woul d cease
bei ng small and t he fixed i nt erest rat e assumpt i on woul d be vi ol at ed. If, on t he
ot her hand, the count ry' s growt h rat e event ual l y converges to t he worl d gr owt h
rat e, the count r y' s ability and desire to bor r ow f r om worl d capital mar ket s are
reduced.
3.1.2. The role o f comparative advantage
The t heor y of i nt er nat i onal t rade offers a useful perspect i ve on t hese results.
The r eason is t hat foreign borrowi ng and l endi ng can be vi ewed as intertemporal
trade, t hat is, as t he exchange of consumpt i on avai l abl e on di fferent dates. The
principle of comparat i ve advant age t hus applies.
I magi ne t hat t he home count r y faces a const ant worl d i nt erest rat e equal t o
l + r = 1/ f l and t hat lit > Ys for s > t. Equat i on (3.9) predicts t hat (absent ot her
c ur r e nt - pe r ma ne nt di fferences) the count r y will have a current -account surplus.
The principle of comparat i ve advant age makes t he same prediction. In the ab-
sence of t rade, t he count ry' s aut ar ky i nt erest rates, equal to u' (Yt )/ ~' ~-t u' (Y~),
lie bel ow t he correspondi ng worl d i nt erest rates, (1 + r) s~t. It t her ef or e pays for
t he r epr esent at i ve resi dent to export present consumpt i on by l endi ng abroad,
since pr esent consumpt i on is compar at i vel y cheap at home, and to i mpor t f ut ur e
consumpt i on by receiving r epayment for t he loans at a l at er date.
Similarly, t empor ar i l y hi gh i nvest ment needs can raise a count ry' s aut ar ky in-
t erest rat e above t he worl d level, maki ng it an i mpor t er of present consumpt i on,
t hat is, an ext ernal borrower.
Thi s perspect i ve makes clear t hat it is onl y t he country-specific or i di osyncrat i c
component s of shocks t hat result in current -account imbalances. The gl obal
component s of shocks, in contrast, affect all count ri es similarly and t hus open up
no new oppor t uni t i es for gains t hr ough i nt er t empor al t rade. Count ri es cannot all
Ch. 34: The lntertemporal Approach to the Current Account 1749
smoot h consumpt i on perfect l y in the face of a shock t hat t empor ar i l y depresses
worl d out put , for exampl e. Inst ead, t he world real i nt erest rat e is bid up and all
count ri es tilt t hei r consumpt i on pat hs upward.
3. 1. 3. Mo d e l i n g o u t p u t f l u c t u a t i o n s a n d i n v e s t me n t
Our earl i er i nvest ment exampl e assumed t hat a nat i on' s capital stock can bc
adj ust ed wi t hout cost to equat e capital' s margi nal product to the worl d i nt erest
rate. Empi ri cal obser vat i on makes this assumpt i on difficult to swallow: even a',
t he i ndust ry level, we si mpl y do not observe large di scret e changes in stocks of
capital over ver y short periods. If t here are costs to installing capital, however,
capital stocks will move mor e sluggishly and pr ot r act ed devi at i ons of capital' >
margi nal pr oduct from r are possible. A simple model illustrates how costly
i nvest ment affects current -account dynamics. 12
As s ume t hat final out put is pr oduced according to the st andar d homogeneous
and concave pr oduct i on funct i on Ot F( Kt , Lt ), where, as before, Ot capt ures shifts
in t ot al fact or product i vi t y, and where Kt is given by past i nvest ment decisions.
A firm maki ng decisions on dat e t maxi mi zes t he pr esent di scount ed val ue of
its profits (which equal t he di vi dends sharehol ders receive):
[ a I 2 ]
~ _ _ , R , , , O , F ( K , , L s ) - w , r s - 1 ~ - 5 g ] , J ( 3 . 1 1 )
S=f
Above, a e 7 ( I . ; / Kt ) is the deadwei ght out put cost of installing
K ~ + 1 - K , = I t ( 3 . l 2 ~
units of capital, where a > 0 is an adj ust ment -cost paramet er. Accordi ng to
(3.11), t he efficiency of i nvest ment in produci ng i nst al l ed capital declines at an
increasing rat e as t he rat i o of i nvest ment to i nst al l ed capital rises. Gi ven (3.11),
t he economy' s net out put on dat e t is Yt = Ot F( Kt , L t ) - ~ ( I 2 / K t ) .
The condi t i ons for maxi mi zi ng profits (3.11) subject to (3.12) i ncl ude
I , - qt - 1 g , ( 3 . 1 3 )
a
and the i nvest ment Eul er equat i on
a 2
Ot+IFK(K,+I, gt+l) + ~( l , +l / Kt +l ) + q, <
= (3.14)
qt 1 + rt+ 1
12Matsuyama (1987) develops an open-economy model with costly investment. The effects of
residential investment are studied in Matsuyama (1990).
1750 M. Obst f el d and K. Ro g o f f
wher e qt (Tobin' s q) is the Lagr ange mul t i pl i er on const rai nt (3.12) and has t he
usual i nt er pr et at i on as the shadow price of i nst al l ed capital.
For war d i t er at i on on (3.14) shows t hat
qt = ~ Rt , s [ O s F K ( K s , L s ) + 2(I s~Ks)2]
s = t + l
(3.15)
(we have excl uded bubbles in t he price of capital). Equat i on (3.15) states t hat
qt , t he e x d i v i d e n d shadow price of a uni t of capi t al at the end of peri od t,
equal s the pr esent val ue of its fut ure margi nal product s plus t he present val ue
of its f ut ur e cont ri but i ons to l oweri ng t he costs of i nvest ment . 13
Mul t i pl y eq. (3.14) by Kt+l and use eq. (3.12) to express it as
a 2
Ot +I FK( Kt +I , L t +I ) Kt +I q- 2 ( I ; +1 / K r + I ) q- qt+l (Kt+2 - It+~)
~l t " t +l : 1 + rt+l
Because t he pr oduct i on funct i on is homogeneous of degree one and qt+l z
1 + a ( I t +l / Kt +l ) [recall eq. (3.13)], the foregoi ng rel at i onshi p, i t er at ed forward
successively to el i mi nat e t erms of form q~Ks+l , i mpl i es t hat
qt Kt +l = Rt , s Os F ( K, , L s ) - ws L s - l s - 2Kss ] ~ Vt+l
s = t + l
(3.16)
Thus, t he opt i mi zi ng firm' s e x d i v i d e n d mar ket val ue at the end of peri od t,
Vt+I, is t he same as the shadow val ue of its i nst al l ed capital: in Hayashi ' s (1982)
t ermi nol ogy, average q equal s margi nal q.i4
To see some of the model ' s predi ct i ons for current account and i nvest ment
dynami cs, let us simplify by assumi ng t hat r, 0, and L are const ant and consi der
a si t uat i on in whi ch the capital stock K is i ni t i al l y bel ow its st eady st at e level.
Thus t he mar gi nal product of capital, OF K( Kt , L ) exceeds r, q > 1, and bot h K
and Y are expect ed to rise over time. As t he capital st ock rises t owar d its st eady-
st at e level, K, wher e OFK( f f ; , L ) = r, q falls to one. is Accordi ng to (3.9) t he
cur r ent account (abstracting from gover nment - spendi ng changes, and assumi ng
t he economy consists of a represent at i ve firm owned by a represent at i ve agent )
1 3 E q u a t i o n ( 3. 15) d e f i n e s t h e ex di vi dend s h a d o w p r i c e o n d a t e t b e c a u s e i t d o e s n o t i n c l u d e t h e
p r o f i t e a r n e d o n t h a t d a t e a n d p a i d o u t t o s h a r e h o l d e r s as d i v i d e n d s .
14As H a y a s h i s h o ws , t h i s e q u a l i t y i s d u e t o t h e h o m o g e n e i t y o f d e g r e e o n e of t h e p r o d u c t i o n a n d
i n s t a l l a t i o n - c o s t f u n c t i o n s .
l S F o r d i s c u s s i o n s o f t h e s e d y n a mi c s , s e e A b e l ( 1982) a n d S u m m e r s ( 1981) .
Ch. 34: The Interternporal Approach to the Current Account
is gi ven by
1751
{ r E
O F ( K t , L ) 2Kt ] l + r s=t
C A t
r ~ ( 1 ~s t q s - - 1 K s ]
- a 1 + r s=t - - U-
Since K is rising over t i me, final out put is rising over t i me as well. Since
i nves t ment also is falling, 16 dat e t i nst al l at i on costs exceed t hei r pe r ma ne nt level.
Thus, l~t = O F ( K t , L ) - a : ~ ( I i / K t ) falls short of its pe r ma ne nt l evel , cont r i but i ng
a negat i ve c ompone nt t o t he cur r ent account . The fact t hat i nvest ment also
is above its pe r ma ne nt l evel cont r i but es a second negat i ve c ompone nt to t he
cur r ent account .
Suppose K i ni t i al l y lies bel ow its l ong- r un st eady- st at e val ue because t he
e c onomy has j ust exper i enced an unant i ci pat ed pe r ma ne nt i ncrease in f act or
product i vi t y, 0. We can see f r om t he pr ecedi ng analysis t hat t he e c onomy runs
a cur r ent - account deficit. A classical exampl e of this dynami c is Nor way in t he
1970s (Fi gure 2.3), whi ch bor r owed ext ensi vel y t o bui l d up its Nor t h Sea oil
pr oduct i on fol l owi ng t he first oi l -pri ce shock.
Not e t hat an unant i ci pat ed pe r ma ne nt rise in 0 not onl y l eads t o a cur r ent
account deficit but causes an i mmedi at e rise in out put as well. Ther ef or e, with
pr oduct i vi t y shocks t he model can in pri nci pl e expl ai n t he wel l - document ed
count er cyel i cal behavi or of t he cur r ent account , t7 Of course, this resul t rests
on t he assumpt i on t hat t he rise in 0 is per manent . I magi ne, in cont rast , an
unexpect ed rise in 0t l ast i ng onl y a single per i od. Thi s change will not affect
i nves t ment pl ans f or f ut ur e dat es, and so t he onl y ef f ect is a l evel of out put
t empor ar i l y above t he pe r ma ne nt level. Equat i on (3.9) shows t hat a cur r ent
account surplus will arise on dat e t. Pr oduct i vi t y shocks wi t h gr eat er per si st ence
cause some i nvest ment and hence smal l er initial cur r ent - account surpluses, and,
if per si st ent enough, t hey can pr oduce an initial deficit, as in t he pe r ma ne nt
c a s e .
16I nvest ment equal s (q - ])K/a, but wi t h q falling whi l e K is rising, it may not be obvi ous t hat 1
falls over t i me. The as s er t i on in t he t ext is al ways t r ue in t he ne i ghbor hood of t he s t eady st at e. To
see why, obs er ve t hat
It+i-It = Kt [ ~ q t ) + ( qt . l - a 21)(qt-1)]_
t o a f i r st - or der appr oxi mat i on.
17See t he art i cl e by Mor r i s Gol dst ei n and Mohsi n S. Khan in vol ume 2 of this Ha ndbook (Gol d-
st ei n and Kha n 1985).
The r eader shoul d not e t hat in t he pr es ent one- good smal l - economy model ,
changes in i nvest ment can affect consumpt i on, but i nvest ment itself is det er -
mi ned by el ement s t hat are independent of cons umpt i on pr ef er ences. I nves t ment
deci si ons ar e ma de t o maxi mi ze t he pr esent di scount ed val ue of t he count r y' s
out put , eval uat ed at t he wor l d i nt er est rat e. The count r y' s saving behavi or is ir--
r el evant . Thi s i ndependence of i nvest ment f r om cons umpt i on pr ef er ences need
not hol d i f t he economy uses capi t al t o pr oduce nont r aded goods and servi ces
as well as t r adeabl es; it can also br eak down if t her e is a nont r aded i nput in
pr oduct i on, such as labor. I nt r oduci ng nont r aded goods and servi ces l eads t o
a numbe r of ot her modi fi cat i ons of our basi c one- good model ' s results, as we
shall see in t he next section.
3.1.4. Nontradeables, consumption, and investment
An e c onomy t hat consumes and pr oduces nont r adeabl es as wel l as t r adeabl es
ma y behave qui t e di f f er ent l y f r om t he one exami ned so far. We begi n by seei ng
how nont r adeabl es can affect consumpt i on decisions.
In this sect i on, it will be conveni ent t o r ei nt er pr et C as a composi t e index
of t he r epr es ent at i ve i ndi vi dual ' s cons umpt i on of t r adeabl es and nont r adeabl es,
CT and CN, but r et ai n t he assumpt i on t hat t he per i od ut i l i t y f unct i on u(C) is
i soel ast i c wi t h i nt er t empor al subst i t ut i on el ast i ci t y o-. Assume, mor eover , t hat
compos i t e cons umpt i on C has t he CES form:
C = [c~l/C (-1)/ + (1 - 'a)l/"C(y-l)/]/(-l) (3.17)
He r e , p is t he ( i nt r at empor al ) subst i t ut i on el ast i ci t y bet ween t r adeabl es and
nont r adeabl es. Take t r adeabl es as t he numer ai r e commodi t y and l et p be t he
pri ce of nont r adeabl es in t er ms of t r adeabl es. Then, as one can easi l y show, t he
exact consumer - pr i ce i ndex (CPI) in t r adeabl es, def i ned as t he mi ni mal cost in
t r adeabl es of a uni t of subut i l i t y C, is gi ven by
P = [a + (1 - cOpl-] l/(1-) (3.18)
For t he speci al case O = 1 ( Cobb- Dougl as pr ef er ences) , P = pl 4. Thes e same
cal cul at i ons r eveal t hat , gi ven C, t he opt i mal cons umpt i on levels f or t r adeabl es
and nont r adeabl es are:
CT = c~ C, CN = (1 -- c~) C (3.19)
Gi ven t he i nt r at empor al al l ocat i on rul es in (3.19), t he consumer ' s intertempo-
ral deci si on pr obl em can be anal yzed ent i r el y in t er ms of composi t e cons umpt i on
C and t he pri ce i ndex P. The cons umer maxi mi zes (3.4) subj ect t o t he budget
const r ai nt cor r espondi ng t o (3.5) but wr i t t en in t er ms of expendi t ur e on C:
O<3 O0
E Rt,sPsCs = (1 + rt)(Vt + Bt ) + Z n, , s( wsLs - Ts)
s=t s=t
( Above, asset stocks, wages, and t axes still are expr essed in units of t r adeabl e@
The i nt er t empor al Eul e r equat i on f or t he consumpt i on i ndex C is now
c , + ~ = / 3 ~ ( l + r t + ~ ) ~ ~ c~ . . . .
Thi s r el at i onshi p is anal ogous to Eul e r eq. (3.7), except t hat over al l consumF, li.<,~
gr owt h depends on t he ut i l i t y-based real i nt er est f act or (1 + rf+l)(Pt/Pt+! ), and
not si mpl y on t he r el at i ve i nt er t empor al pri ce of t r adeabl es 1 + rt ~1. [Dornbuscl"
(1983) stresses this point. ] Combi ni ng eqs. (3.19) and (3.20) shows t hat t he Eul er
equat i on f or tradeables expendi t ur e, CT , is
CTt+I = / 3 ( 1 + r t +l ) ( Pt ~ -0 CTt (3.21)
Pt+l J
Equat i ons (3,20) and (3.21) show, in part i cul ar, t hat consumpt i on need no
l onger be i nt er t empor al l y s moot hed when t he t i me- pr ef er ence r at e and worl d
t r adeabl e goods i nt er est r at e coi nci de. For exampl e, if t he CPI, P, is rising over
t i me, t he real i nt er est r at e will be bel ow t he own i nt er est r at e on t r adeabl es,
r. So t ot al cons umpt i on expendi t ur e measured in tradeables, P C, will fall over
t i me if o- > 1 and rise over t i me if o- < 1. Similarly, whi l e a rising pat h of P
tilts t hat of C downwar d wi t h an el ast i ci t y or, t he pri ce changes cause CT to rise
r el at i ve t o C wi t h el ast i ci t y p [see eq. (3.19)]. If p > o- and 13(1 + r) = 1, for
exampl e, cons umpt i on of t r adeabl es will rise over t i me if P is rising} s
Some gener al - equi l i br i um i mpl i cat i ons of t hese poi nt s can be i l l ust rat ed by a
si mpl e model in whi ch t he economy' s out put of nont r adeabl es, YN, is exogenous.
I f we assume ( f or si mpl i ci t y) t hat nei t her t he gover nment nor t he domest i c
i nves t ment pr ocess uses up nont r adeabl es, t hen t he condi t i on of equi l i br i um
in t he nont r adeabl e sect or is si mpl y CN = YN, and by (3.19) t he equi l i br i um
r el at i ve pr i ce of nont r adeabl es is
- - o l ) C T ] 1 / p
p = [[ (1 ~ - N ]
In t he Cobb- Dougl a s case p -- 1, and it is si mpl e t o wri t e down t he equilibo
r i um gr owt h pr ocess f or t r adeabl es cons umpt i on by combi ni ng t he pr ecedi ng
expr essi on wi t h eq. (3.21):
(1 . ) ( ~ - 1 )
o- ( YNt+l "~ ,~--(~-I)
CT,< = / 3 ~ ( 1 + r t < ) ~ \ YYt J CTt (3.22)
18For a panel of 13 developing countries, Ostry and Reinhart (1992) present Euler-eqnation
estimates of ~r = 1.27 or 1.22 and p = 0.38 or 0.50 (depending on the instrumental variables used
in estimation). These results indicate that the case o- > p may be relevant.
:1754 M. Obstfeld and K. Rogof f
Not i ce t hat even when nont r adeabl es out put is const ant , t he gr owt h of t r ade-
abl es cons umpt i on usual l y reflects t he pr esence of nont r adeabl es in t he con-
sumpt i on basket . The reason: gr owt h in CT affect s p and thus t he domest i c r eal
i nt er est r at e.
A f undament al i mpl i cat i on of t hese resul t s is t hat empi ri cal st udi es of t he in-
t e r t e mpor a l appr oach shoul d distinguish car ef ul l y be t we e n fl uct uat i ons in t r aded
and nont r aded out put s. As an exampl e, suppose t hat t he pat h of t r aded out put
is flat, t hat /3(1 + r) = 1, and t hat YNt < YNt+l. Accor di ng t o eq. (3.22), con-
sumpt i on of t r adeabl es will be rising if o- > 1 and fal l i ng if o- < 1. Because t he
cur r ent account surplus is t he di f f er ence bet ween t he economy' s e ndowme nt of
t r adeabl es and its absor pt i on of t r adeabl es, even t he sign of t he cur r ent account
bal ance ma y not be r el at ed in a si mpl e way t o t he t i me pat h of t he economy' s
t ot al real out put .
One can add a l abor-l ei sure t r adeof f t o t he i nt er t empor al model by vi ewi ng
l ei sure as a nont r adeabl e (assumi ng t her e is no i nt er nat i onal mi grat i on). In this
cont ext t he r eal wage pl ays t he rol e t hat t he r el at i ve pri ce of nont r adeabl es p
pl ayed above. ~9
Al so, as we suggest ed at t he end of t he pr ecedi ng section, t he pr esence of
a sect or pr oduci ng nont r adeabl es per mi t s domest i c cons umpt i on pr ef er ences t o
af f ect t he economy' s i nvest ment behavi or. A shift in pr ef er ences t owar d non-
t r adeabl es, f or i nst ance, will r educe i nvest ment if t he nont r adeabl es sect or i s
t he r el at i vel y l abor - i nt ensi ve one. 2
Al l owi ng f or nont r adeabl es is an i mpor t ant st ep t owar ds havi ng a mor e real -
istic model of cur r ent account behavi or. In t he next sect i on we consi der a not he r
i mpor t ant modi fi cat i on.
3.1.5. Consumer durables and the current account
Ei ght een per cent of 1993 Uni t ed St at es cons umpt i on spendi ng was devot ed t o
dur abl es (i ncl udi ng cl ot hi ng and shoes). But t he t he or y we have devel oped t hus
f ar does not capt ur e t he possi bi l i t y t hat cons umer pur chases in one per i od ma y
yi el d ut i l i t y over several peri ods. We now i l l ust rat e how t he pr esence of dur abl es
can al t er cur r ent account responses.
In this subsect i on, l et C st and f or t he i ndi vi dual ' s cons umpt i on of nondur abl es
and l et D be t he stock of dur abl es he or she owns; all goods can be t r aded. A
st ock D of dur abl es yi el ds a pr opor t i onal servi ce flow each per i od, i ncl udi ng
t he per i od in whi ch it is acqui red. The cons umer in a small count r y maxi mi zes
u , = / 3 s - ~ [ ~ l o g c , , + ( 1 - ~ ) l o g D , ]
s t
19For an early analysis of the effects of introducing nontraded labor on current account dynamics,
see Bean (1986).
2See, for example, Murphy (1986) and Engel and Kletzer (1989).
Ch. 34: The l nt ert ernporal Ap p r o a c h to t he Current Ac c o u n t 1755
subj ect t o t he fi nance const r ai nt s
At +l - - A t = r At + Yt - Ct - Gt - (Kt+j - Kt ) - p t [ Dt - (1 - 6) Dt - l l
and a sol vency condi t i on. Her e, Dt is t he st ock of dur abl es (including newl y
pur chas ed dur abl es) hel d over per i od t, Pt is t hei r pr i ce in t er ms of non-
dur abl es, 6 is t hei r depr eci at i on r at e, and r, t he wor l d i nt er est r at e, is const ant .
Not e t hat A, Y, C, G, and K are meas ur ed in nondur abl es. Dur abi l i t y i mpl i es
6 < 1 .
In addi t i on t o t he usual i nt er t empor al Eul e r equat i on f or nondur abl es c o n
sumpt i on, t he i ndi vi dual ' s fi rst -order condi t i ons i ncl ude
a Dt - - P t - ~ P t < =- ~t,
whi ch equat es t he mar gi nal r at e of subst i t ut i on of nondur abl es f or t he services
of dur abl es t o t he us er c os t or r ent al pri ce of durabl es.
As s umi ng/ 3 = 1/ ( 1 + r), cons umpt i on of nondur abl es is
Ct = -~-+-Tr ( l + r ) At + ( 1 - a ) p t Dt _ , + \ ~+Tr /t (Y~ - ls - Gs )
s=t
whi l e cons umpt i on of dur abl es' services is
0 - - ~ ) r 1 ( v, t,, - G)
Dt - - ~( l +r ) ( l +r ) A t +( 1 - 6 ) p t Dt =l + l +r ~ "
S=t
Let ' s suppose f or si mpl i ci t y t hat , Pt and, hence, t he user cost, Lt, are const ant .
The last equat i ons t hen i mpl y t hat t he cons umer smoot hs, not t he pat h of expen-
di t ur es p [ Dt - ( 1 - 6) Dr _l ] on durabl es, but t he s e r v i c e flow f r om durabl es, which
is pr opor t i onal t o Dt . Wi t h durabl es, t he cur r ent account is t he same as i mpl i ed
by (3.9) (assuming, as we have her e, t hat r = (1 - / 3 ) / ~ ) , but wi t h an addi t i onal
t er m t hat depends on new dur abl es pur chases ( we o mi t t he de r i v at i on) :
= {(Yt - Y t ) - ( Gt - ~at) - (It - J, )} + (~ - p) AD, (3.23) C A t
Not i ng t hat t he pri ce of purchasi ng a dur abl e out r i ght , p, must be gr eat er
Tha n t he one- per i od user cost ~, we see t hat t he i nt r oduct i on of dur abl es neces-
sari l y i ncreases t he vol at i l i t y of cur r ent - account r esponses t o unexpect ed i ncome
changes.
3. 1. 6. T h e t e r ms o f t r ade a n d t he t r ans f e r p r o b l e m
One of t he earl i est pr obl ems mot i vat i ng t he i nt er t empor al appr oach was t he
need t o under s t and how changes in t he t er ms of t r ade - t he pr i ce of a count r y' s
1756 M. Obst f el d and K. Ro g o f f
expor t s in t er ms of its i mpor t s - affect saving and t he cur r ent account . Ear l y ap-
pl i cat i ons of Keynes i an model s by Ha r be r ge r (1950) and Laur s en and Met zl er
(1950) had mode l e d adver se t er ms- of - t r ade shocks as real i ncome- r educt i ons
t hat r educe savi ng and t he ext er nal surplus in pr opor t i on to Keynes' s mar gi nal
pr opens i t y t o save. Inst ead, t he i nt er t empor al appr oach emphasi zed t he re-
sponse of f or war d- l ooki ng i ndi vi dual s t o t he changes in l i f et i me cons umpt i on
possi bi l i t i es t hat t er ms- of - t r ade movement s cause.
The si mpl est case is of a speci al i zed e c onomy wi t h an exogenous e ndowme nt
Y of its expor t good, but whi ch also consumes i mport s. As in t he model wi t h
nont r adeabl es , we agai n assmne an i soel ast i c per i od ut i l i t y f unct i on def i ned over
a CES i ndex C; her e it depends on t he i ndi vi dual ' s consumpt i ons C~t of i mpor t s
and Cx of export s:
Le t p now de not e t he pri ce of expor t s in t er ms of i mport s, whi ch is det er mi ned
exogenous l y in t he wor l d mar ket . The cons umpt i on- bas ed pri ce l evel in t er ms
of i mpor t s is agai n denot ed by P and gi ven by f or mul a (3.18).
The nat ur al benchmar k case, assumed by Svensson and Razi n (1983), sup-
poses t hat i nt er t empor al t r ade is done t hr ough bonds i ndexed t o t he consump-
t i on i ndex, C. I n this case r is t he own r at e of i nt er est on t he cons umpt i on
i ndex, and t he budget const r ai nt cor r espondi ng t o (3.3) in t he pr esent set up
( abst r act i ng f r om i nvest ment and gover nment ) is
2 2
Rt,sCs = (1 + rt)At + Rt,s
S : t S=I
The Eul e r equat i on f or t he consumpt i on i ndex is agai n (3.7), i mpl yi ng t he con-
sumpt i on f unct i on cor r espondi ng t o (3.8), whi ch has I = G = 0 and p Y / P
in pl ace of Y. To focus on t he t er ms of t r ade, it is hel pful t o assume t hat
r = (1 - ~) / / ~ and Y are const ant , in whi ch case t he cons umpt i on f unct i on
r educes to:
Ct = rat + ~ Z \ l~--rr J
S=t
A fall in t he t er ms of t r ade l owers p (t he r el at i ve pr i ce of expor t s in t er ms of
i mpor t s) r el at i ve t o P ( t he overal l CPI in t er ms of i mport s). Thus, fl uct uat i ons
in t he t er ms of t r ade affect t he cons umpt i on i ndex and t he cur r ent account
(whi ch he r e is meas ur ed in consumpt i on- i ndex units) exact l y like fl uct uat i ons
in GDP at const ant t er ms of t rade. In part i cul ar, a t e mpor a r y t er ms - of - t r ade
set back causes a cur r ent - account deficit, wher eas a pe r ma ne nt set back causes
an i mmedi at e shi ft t o t he new, l ower cons umpt i on l evel consi st ent wi t h ext er nal
Ch. 34. The Intertemporal Approach to the Current Account
40
C
P 30
20
"8
P 10
"~ 0
O
e e
"6
-10
e e
-20
AUS
USA
NOR
JAP
NET ITA FRA
SWE B m SPA BGE R
DEN
& "c""
BEL
-0.15 -0.1 -0.05 0 0.05 0.1 0.15
Change in Net Forei gn Asset s/ GDP
Figure 3.1. Real currency appreciation versus the change ill foreign assets, 1981-1990.
1757
balance. Obstfeld (1982) and Svensson and Razin (1983) illustrate how this latter
result depends on the strong intertemporal separability of utility. 21
This subsection has, thus far, focused on the response of the current account to
exogenous terms-of-trade changes. When countries have some monopoly power
in trade, however, shifts in their current accounts may influence terms of trade
by redistributing wealth internationally.
The impact of international wealth transfers on the terms of trade is a classic
problem of international finance. In the 1920s, Keynes and Ohlin disagreed on
the price effects of German reparations; in the 1990s, observers of the protracted
United States external deficits have debated the need for a fall in the relative
price of American exports. 22
For a cross-section of 15 OECD countries, Figure 3.1 plots the percent change
in the trade-weighted WPI real exchange rate (a terms-of-trade proxy) against
the change in the ratio of net foreign assets to output. The net foreign asset
series attempt to account not only for measured current account flows, but for
21Ostry (1988) and Edwards (1989) study interactions between the terms of trade and the relative
price of nontradeables. Gavin (1990) considers the terms of trade in a richer dynamic setting. For
developing countries, it may be natural to assume that bonds are indexed to imports (e.g. "dollars").
In that case the intertemporal budget constraint differs from the one we have analyzed, so that the
Euler equation for C is formally the same as (3.20). If the world bond rate is constant, expected terms
of trade movements therefore have consumption-tilting effects through the consumption-based real
interest rate.
22See, for example, the papers in Bergsten (1991).
capi t al gai ns and losses. 23 The changes are cal cul at ed as t he 1986-1990 aver age
less t he 1981-1985 average.
The fi gure shows a distinct posi t i ve r el at i onshi p - an i ncrease in a count r y' s
net f or ei gn assets appear s t o be associ at ed wi t h an i mpr ove me nt in its t er ms of
t r ade. The l east - squar es r egr essi on line is
A l og( pj ) = 0.039 + 1. 0422x(A/Y)j + uj; R 2 = 0.31
(0.027) (0.433)
i mpl yi ng a st at i st i cal l y significant rel at i onshi p. Accor di ng t o t he regressi on, an
i ncr ease of 1 per cent in t he r at i o of net f or ei gn assets t o out put is associ at ed
wi t h a 1 per cent i mpr ove me nt in t he t er ms of t r ade.
Obvi ousl y, this regressi on pr ovi des onl y a nonst r uct ur al cor r el at i on. To assess
accur at el y t he consequences of an exogenous weal t h t r ansf er woul d r equi r e
a full e c onome t r i c st ruct ural model . Gi ven t he per enni al i mpor t ance of t he
t r ansf er ef f ect in pol i cy discussions, t he de ve l opme nt of empi ri cal i nt er t empor al
model s t hat can expl ai n its magni t ude is a r esear ch priority.
Theor et i cal l y, t he t r ansf er ef f ect can oper at e t hr ough several channel s in a
gener al - equi l i br i um setting. Two pot ent i al mechani sms are home pr ef er ence f or
domest i c expor t s [see, f or exampl e, Bui t er (1989)] and t he pr esence of a non-
t r adeabl es sect or t hat compet es f or r esour ces wi t h t he expor t abl e sector. A
speci al case of t he l at t er mechani sm is due t o t he ef f ect of a weal t h change on
l abor suppl y and, hence, on t he suppl y of expor t abl es.
A si mpl e t wo- count r y model exhi bi t s t he l abor - suppl y channel f or t he t r ansf er
effect . As s ume t hat t he home count r y speci al i zes in pr oduci ng good X and
t he f or ei gn count r y good M. Mor eover , assume t hat in bot h count r i es p, t he
el ast i ci t y of subst i t ut i on in demand bet ween t he t wo pr oduced goods, equal s
1. Le t t he per i od ut i l i t y funct i on, c ommon t o t he home and f or ei gn count r i es,
be an i soel ast i c f unct i on of an i ndex t hat depends on bot h cons umpt i on and
l ei sure,
( H - = - ) ( H -
C ~ L ) I - ~
wher e 0 < ~ < 1, H is an i ndi vi dual ' s e ndowme nt of t i me, and L his or her
l abor supply. Le t home out put be pr oduced accor di ng t o t he pr oduct i on f unct i on
Y = wL and f or ei gn out put accordi ng t o Y* = ~o*L*. Le t P once agai n denot e
23Real exchange r at e dat a come from Int ernat i onal Monet ar y Fund, International Financial Statis-
tics. Net foreign asset positions come from OECD Economic Outlook 55 (June 1994), p. A54. The
count ry sampl e is Aust ral i a (for which t he CPI was used), Bel gi um-Luxembourg, Canada, Den-
mark, Finland, France, Germany, Italy, Japan, Net herl ands, Norway, Spain, Sweden, t he Uni t ed
States, and t he Uni t ed Kingdom. We are skeptical t hat t he real appreci at i on of 33 percent t hat t he
I MF report s for Norway is accurate. (The I MF report s a similar number based on CPIs.) OECD
dat a place Norway' s real appreci at i on over 1981-1990 closer to 15 percent . However, t he observat i on
on Norway is not driving t he regression results report ed below.
t he pr i ce of t he i ndex C in t er ms of home i mport s, and assume bonds are
i ndexed t o C. The home count r y' s net ext er nal assets are A, and t he f or ei gn
count r y' s, t her ef or e, ar e - A. Usi ng t he st eady- st at e cons umpt i on funct i ons to
sol ve f or de ma nd and suppl y in ei t her of t he goods mar ket s, one can show ( af t er
ma n y s t eps ) t hat t he equi l i br i um t er ms of t r ade satisfy t he condi t i on
poea~H (1 - oe)w*H* _ (1 - (:)(1 - f l ) . A
e P ~/3
Fr om this i mpl i ci t t er ms- of - t r ade equat i on one can easi l y see t he effect .,!
an exogenous shift in net ext er nal assets f r om t he f or ei gn to t he home count-~y
(t hat is, of a ri se in A). An absol ut e rise in p, t he r el at i ve pr i ce of home ex-
port s, raises p r el at i ve t o P, and P itself rises absol ut el y. If A rises, a rise m
p t her ef or e mai nt ai ns equi l i bri um. The i nt ui t i on why a weal t h t r ansf er to t he
home count r y i mpr oves its t er ms of t r ade is simple. If home resi dent s r ecei ve a
financial wi ndfal l , t hey spend some of it on leisure. Out put of t he home good
t hus falls and its r el at i ve pri ce must rise.
3. 1. Z De mo g r a p h i c st ruct ure, f i s c al pol i cy, a n d t he c ur r e nt a c c o u n t
The single r epr es ent at i ve agent par adi gm f ol l owed so far in this chapt er may
furni sh mi sl eadi ng pr edi ct i ons about t he cur r ent account when t he economy con-
sists i nst ead of het er ogeneous fami l i es bor n on di f f er ent dat es and unconnect ed
by al t rui st i c links. A model based on t he over l appi ng- gener at i ons st r uct ur e in
Weil (1989) i l l ust rat es some possi bl e i mpl i cat i ons of al l owi ng f or demogr aphi c
compl exi t y. 24
We will i dent i f y t he economy' s t ot al popul at i on wi t h its l abor supply, Lt ,
whi ch grows at r at e n: Lt+ 1 = (1 + n ) L t , wi t h L0 nor mal i zed to 1. Thi s l abor
f or ce, however , consists of i mmor t al unconnect ed i ndi vi dual s (or dynast i es) bor n
on successive dat es. A r epr esent at i ve f r om t he gener at i on bor n on dat e v (t he
gener at i on' s " vi nt age" ) maxi mi zes Uo,t = ~ . ~ t fls t u( Co, , ) subj ect t o
oo OO
s=t s - t
( wher e Bv,t denot es vi nt age v' s bond hol di ngs and each i ndi vi dual supplies one
uni t of l abor per per i od) . Not i ce t hat cons umpt i on and weal t h are vi nt age-
specific, wher eas all peopl e face t he same wage, i nt er est rat es, and (by assump
t i on) l ump- sum taxes. A key assumpt i on is t hat Vv,~ = By# = 0: vi nt ages are
bor n wi t h no fi nanci al weal t h, onl y with a l i f et i me e ndowme nt equal t o t he
2aFor alternative open-economy models with overlapping generations, see Buiter (1981, 1989),
Blanchard (1985), Persson (1985), Frenkel and Razin (1987), and Eaton (1988).
1760 M. Obs t f el d and K. Ro g o f f
pr es ent val ue of aft er-t ax l abor i ncome. ( One can t hi nk of t he model as one in
whi ch pr i mogeni t ur e gover ns t he beques t of f ami l y weal t h. ) I nves t ment can be
mode l e d exact l y as in Sect i on 3.1.3. The onl y di f f er ence is t hat a growi ng l abor
f or ce r equi r es posi t i ve st eady- st at e i nvest ment .
To ma ke t he mai n poi nt s it suffices t o wor k wi t h t he special case in whi ch t he
i nt er est r at e is const ant at r and t he per i od ut i l i t y f unct i on is u ( C ) = l o g ( C) Y In
this case,
Cv, t --- (1 - / 3 ) (1 + r ) ( V v , t + B y , t ) + Z ( w s - T s ) (3.24)
S=t
is t he cons umpt i on funct i on.
In i nvest i gat i ng t he economy' s aggr egat e behavi or, it is hel pful t o wor k wi t h
per capi t a aggr egat e measur es of macr o- var i abl es such as cons umpt i on and
weal t h. As s ume t hat t he e c onomy starts on dat e 0. Let X v , t be t he vi nt age-
specific val ue of var i abl e X on dat e t. Obs er ve t hat t he size of gener at i on
v = 0 is 1, t hat of gener at i on 1 is (1 + n) - 1 = n, t hat of gener at i on 2 is
(1 + n) 2 - (1 + 17) = n(1 + n), and so on up t hr ough vi nt age t, whi ch is of size
n(1 + n ) t a. Thus t he per capi t a aver age val ue of X on dat e t is:
X t = X o , t + n X l , t + n(1 + n ) X 2 , t + . . . + n(1 + n ) t - l X t , t
(1 + n ) t (3.25)
To comput e aggr egat e per capi t a consumpt i on, obs er ve t hat Vt, def i ned as in
t he last equat i on, is t he aver age per capi t a val ue of claims t o domest i c firms
at t he end of per i od t - 1 and is still gi ven by (3.11) if t he quant i t i es in t hat
equat i on ar e i nt er pr et ed as per capi t a aggregat es. Equat i ons (3.11), (3.24), and
(3.25) t hus i mpl y 26
Ct = (1 - / 3 ) (1 + r ) B t + Z ( Y s - T s - I s ) (3.26)
S=t
Above, cons umpt i on has be e n expr essed as a f unct i on of t he t i me pat h of taxes.
To under s t and t he rol e of t axat i on, however, we must f or t he first t i me in this
chapt er expl i ci t l y consi der exact l y how t he domest i c gover nment coor di nat es
t he t i me pat hs of publ i c expendi t ur es and taxes.
Le t D t now denot e t he gover nment ' s per capi t a debt at t he end of dat e
t - 1. The n if G t denot es per capi t a gover nment consumpt i on, t he i nt er t empor al
publ i c- sect or budget const r ai nt on dat e t is
25This c a s e c o r r e s p o n d s t o i soel ast i e pr e f e r e nc e s wi t h o- = 1.
2670 der i ve t hi s e qua t i on, we a s s u me pe r f e c t f or es i ght b e t we e n da t e s t - 1 and t, so t ha t (1 +r ) Vt =
Yt - w t - I t + Vt+l. Th e n e x t e qua t i on hol ds, however , e ve n wi t hout t he pe r f e c t f or es i ght a s s umpt i on, as
c a n be s e e n by modi f yi ng c o n s u me r s ' i nt e r t e mpor a l budge t c ons t r a i nt s as e xpl a i ne d in t he f oot not e
pr e c e di ng eq. (3.5) above. I n der i vi ng (3.26), we ha ve ma d e us e of t he fact t ha t t he pr oduc t i on
f unct i on is h o mo g e n o u s of de gr e e one.
Ch. 34." The I nt ert emporal Appr oac h to the Current Ac c ount 1761
(l+r)(l+n)tDt+ \ - ~r ] (l+n)SG* = H (1 + n)"T,
S=l ,9=f
This constraint equat es the present value of tax revenues to the present value
of spending plus initial debt. If r < n nei t her the government ' s revenue nor
its spending has a finite present value, so we assume r > n. Division of the
precedi ng constraint by (1 + n) t renders it in per capita t erms as:
0o (1 +n'~ st (1 +n~ '~'
(l +r)Dt +~_~\ l +rj Gs = \ l +r ] Ts
S=t S=t
To see what this constraint implies for private consumption, lead it one period
and observe that
(1 + r)Dt + Gt - Tt
= (3.27)
Dt+l 1 + n
Solving eq. (3.27) for Tt and taking present values, we obtain
\ ~--+-rr,i Ts = (1 + r)Dt - Z \ Hi nDs+ Z \ HI G,,
s=t S=/ +l s=t
which, aft er rearranging, can be expressed in the form:
( 1 ~s-t = ( 1 "~ s-' n
\ HJ Ts HJ Gs+ ( l +r ) ( l - r ) Dt
s=t s =t
_ f 1 , ~s- , ( _~)
-~ \ ~- ~r J n(Ds+ 1 - D, ) (3.28)
S=t
Expressi on (3.28) shows that in the overl appi ng-generat i ons economy, gov-
er nment debt is net wealth to the private sector and higher future government
deficits lower the present value of taxes for those current l y alive, holding the
pat h of gover nment consumpt i on constant. Why is this so? Equat i on (3.27)
shows that if Dt were a unit higher the government would have to raise taxes
in all fut ure peri ods by only r - n to keep the per capita public debt constant.
Thus, an extra unit of government bonds in the hands of someone alive at the
start of date t raises his or her discounted stream of tax liabilities by only
H (r - n) = (l + r) 1- r
5' =t
How do current and future government deficits alter the tax bill of current
generat i ons? Let the government cut per capita taxes by 1 + n units in peri od
t and finance this tax cut by issuing enough additional debt to make Dt+l one
unit higher [see eq. (3.27)]. If the government is to mai nt ai n this new higher
1762 M. Ob s t f e l d a n d K. R o g o f f
per capi t a debt l evel , it mus t rai se t axes by r - n pe r capi t a f r om dat e t + 1 on.
Thus, f or s o me o n e al i ve on dat e t, t he net ef f ect of a defi ci t -fi nanced t ax cut is
t o l ower t he pr e s e nt val ue of t axes by
1 + n - ( r n ) = n
s=t +l
Def i ci t - f i nanced t ax cuts in per i ods af t er t have a cor r es pondi ng di scount ed
ef f ect on t he t ax l i abi l i t i es of t hose al i ve on dat e t.
The me c ha ni s m under l yi ng t hese resul t s is wel l known: t he mor e debt t he
gove r nme nt issues, t he mor e t axes can be shi f t ed ont o f ut ur e gener at i ons yet
unbor n. Sever i ng al t rui st i c l i nks be t we e n t hose al i ve t oday and s ome of t hose
who will be al i ve t omor r ow cr eat es a si t uat i on in whi ch cur r ent gener at i ons
do not ful l y i nt er nal i ze t he f ut ur e t ax l i abi l i t i es ari si ng f r om gove r nme nt debt
issue. If, in cont r ast , n = 0, t her e ar e no f ut ur e ent r ant s to t he e c onomy t o
be t axed and, as (3.28) shows, t he t i me profi l e of gove r nme nt debt no l onger
ma t t e r s t o economi c agent s. I n this case, g o v e r n me n t debt is not net weal t h
and t he Ri car di an equi val ence of deficit- and t ax- f i nanced gove r nme nt expendi -
t ur e hol ds. I n t he r epr es ent at i ve- agent e c onomy cons i der ed earl i er, gove r nme nt
bor r owi ng has no i nfl uence on t he cur r ent account .
Thi s is not t he case here. Because t he e c onomy' s over al l net f or ei gn asset s
a r e A t - - B t - Dt , subst i t ut i on of (3.28) i nt o c ons umpt i on f unct i on (3.26) shows
t hat
C, = (1 - f i ) D t + ~ n ( D s + l - D s )
S=t
+ (1 + r ) A t + \ ] ~ T J ( Y s - I s - G , . )
S~t
I n per capi t a t er ms, t he dat e- t cur r ent account is (1 + n ) A t + l A t = r a t + Y t -
C t - I t - G t , so, ot her t hi ngs equal , a hi gher cur r ent l evel of gove r nme nt debt or
a hi gher t r aj ect or y for f ut ur e gove r nme nt deficits will r ai se cur r ent cons umpt i on
and t he e c onomy' s f or ei gn bor r owi ng.
De s pi t e s ome not abl e epi sodes, it has pr ove n difficult t o ver i f y a st r ong st at i s-
tical cor r el at i on be t we e n budget and cur r ent - account deficits. Bel ow we pr es ent
cr oss- sect i on r egr essi ons f or i ndust r i al i zed count r i es ove r f i ve- year s ubs ampl es
of 1976-1990. 27 Each s ubs ampl e cr oss- sect i on obs er vat i on is f or me d by aver -
27The sampl e consists of t he OECD countries as of 1994, except for Belgium, Luxembour g and
Turkey. The dat a for current -account deficits and cent ral gover nment budget deficits relative to
GDP come from I nt er nat i onal Monet ar y Fund, I nt e r nat i onal Fi n a n c i a l St at i st i cs. Due to lack of data,
Switzerland is omi t t ed from t he 1981-1985 regression and Canada, New Zeal and, and Switzerland
are omi t t ed from t he 1986-90 regression. Regressions based on general gover nment deficits yield
similar results [see Obsffeld and Rogoff (1996), ch. 3].
agi ng a count r y' s annual cur r ent - account surpl us r at i o t o GDP and its cent ral
gove r nme nt deficit r at i o t o GDP.
1976-1980
( CA / Y ) j = - 0. 208 - 0.406 ( d i D/ Y) j + uj; R 2 = 0.23
(0.907) (0.171)
1981-1985
( CA / Y ) I = 0.995 - 0.506 ( A D/ Y ) j + uj; R 2 = 0.32
(1.206) (0.173)
1986-1990
( CA / Y ) j = - 0. 881 - 0.016 ( A D/ Y ) j + uj; R 2 = 0. 00
(0.707) (0.114)
Ov e r t he first t wo s ubs ampl es t her e is a st r ong negat i ve cor r el at i on bet ween
budget deficits and t he cur r ent - account surpl us, as t he over l appi ng- gener at i ons
mode l woul d suggest . 2s Dur i ng t he mos t r ecent s ubs ampl e, however , t he cor r e-
l at i on evapor at es . The l ast r esul t suggest s t hat f act or s ot her t han gove r nme nt
budget s domi na t e d sever al count r i es' cur r ent account s ove r 1986-1990. I f one
runs t he s ame r egr es s i on on a s ampl e t hat i ncl udes non- i ndust r i al i zed count r i es,
t he r esul t s are weaker . Bewar e: t hese si mpl e cor r el at i ons ar e me r e l y suggest i ve
and have no st r uct ur al i nt er pr et at i on. I n part i cul ar, t hey cannot tell us t he ef-
fect of an exogenous i ncr ease in a gove r nme nt ' s budget deficit on t he cur r ent
account . An o t h e r ser i ous issue is t o choose t he a ppr opr i a t e me a s ur e of t he in-
t er gener at i onal i nci dence of budget policies. For exampl e, even if t he social
secur i t y account of t he budget is bal anced, it r epr es ent s a huge t r ans f er f r om
young t o old. Cl earl y, a bet t er under s t andi ng of t he "t wi n defi ci t s" will r equi r e
st r uct ur al model s and car ef ul at t ent i on t o i nt er gener at i onal di st ri but i on.
Model s i ncor por at i ng mor e compl ex demogr aphi cs have i mpor t a nt i mpl i -
cat i ons asi de f r om t hei r pr edi ct i ons about gove r nme nt fi nanci al i mbal ances.
Consi der , f or exampl e, t he i mpl i cat i ons of expect ed pr oduct i vi t y growt h. I n a
r e pr e s e nt a t i ve - a ge nt f r a me wor k, hi gher pr oduct i vi t y gr owt h will t end t o we a ke n
t he cur r ent account as pe opl e bor r ow t oday agai nst hi gher f ut ur e i ncome. (In-
ve s t me nt effect s woul d s t r engt hen this result. ) I n a l i fe-cycl e set t i ng t he i mpl i -
cat i ons of hi gher pr oduct i vi t y gr owt h ar e less clear. I f each i ndi vi dual benefi t s
i dent i cal l y f r om t he change r egar dl ess of his or her age, t he resul t s are much t he
s a me as in a r e pr e s e nt a t i ve - a ge nt model . But s uppos e t hat pr oduct i vi t y gr owt h
rai ses t he l abor i ncomes of young wor ker s but does not af f ect t he l abor i ncomes
of ol der wor ker s. Becaus e young savers will count mo r e heavi l y in aggr egat e
savi ng t han ol d di ssaver s, savi ng will t end to ri se and t he cur r ent account to
28In a sample including four industrialized countries and Mexico, Bernheim (1988) finds a similar
correlation between budget deficits and current-account deficits over 1976-1985.
i mpr ove. De a t o n (1992) discusses how l i fe-cycl e t heor i es mi ght expl ai n t hc ob-
s er ved t endency f or nat i onal savi ng and gr owt h r at es t o be posi t i vel y cor r el at ed
in cross sect i ons.
An i mpor t a nt pr ope r t y of over l appi ng- gener at i ons model s is t hat t hey pe r mi t
a s t eady- s t at e wi t h posi t i ve cons umpt i on f or a smal l open economy, even if
i ndi vi dual s have fixed t i me- pr ef er ence r at es di f f er ent f r om t he wor l d i nt er est
r at e. In t he Wei l (1989) mode l j ust sket ched, f or exampl e, t he smal l e c o n o my
can r each a s t eady st at e even if i ndi vi dual cohor t s ' cons umpt i on l evel s ar e ri si ng
or fal l i ng ove r t i me; what is needed is t hat t he bi r t h r at e of new i ndi vi dual s be
l ar ge e nough t o of f set t he di scr epancy be t we e n/ 3( 1 + r) and 1. I f / 3( 1 + r) < 1,
n > 0 gua r a nt e e s t hi s out come; i f/ 3(1 + r) > 1, t he i nequal i t y/ 3( 1 + r) < 1 + n is
necessary.
3.2. St ochast i c models' o f the current account
A t heor y of cur r ent - account de t e r mi na t i on t hat ma k e s no al l owance f or t he
uncer t ai nt y a bout t he f ut ur e under l yi ng c ons umpt i on and i nves t ment deci si ons
cannot be ful l y sat i sfact ory. Unf or t unat el y, however , t he i nt r oduct i on of st ochas-
t i c e l e me nt s can rai se t he t echni cal difficulty of wr i t i ng down sol ut i ons t o in-
di vi dual s' maxi mi zat i on pr obl e ms by an or der of magni t ude. Bel ow we r evi ew
t he pr edi ct i ons of s ome l eadi ng st ochast i c model s. A ke y t he me emer gi ng f r om
t he di scussi on is t hat t he cur r ent - account r es pons e t o var i ous shocks depends
on whe t he r ma r ke t s exi st f or i nsuri ng agai nst t he shocks' effect s. Thi s t h e me
l eads us, at t he sect i on' s end, t o consi der a model in whi ch t he ext ent t o whi ch
shocks ar e i ns ur abl e is endogenous.
3.2.1. Compl et e market s
The mos t t r act abl e case of uncer t ai nt y is t hat in whi ch i nsur ance ma r ke t s exi st
f or all f ut ur e cont i ngenci es, wi t h out comes ful l y ver i f i abl e and cont r act s ful l y
enf or ceabl e. I n t he classic Ar r o w- De b r e u wor l d of c ompl e t e mar ket s , equi l i b-
r i um r es our ce al l ocat i ons ar e effi ci ent and, f r om a f or mal poi nt of view, t he
e c o n o my can be anal yzed as if per f ect cer t ai nt y appl i ed. The r e ar e si mpl y ma n y
mo r e commodi t i es , commodi t i es now bei ng i ndexed by t he st at e of nat ur e in
whi ch t hey ar e d e ma n d e d and suppl i ed. 29
29International models with complete markets are analyzed by Lucas (1982), Stockman (1988a),
Stulz (1988), Cole and Obstfeld (1991), Stockman and Tesar (1995), Backus, Kehoe, and Kydland
(1992), and Baxter and Crucini (1993a), among many others. Lucas's (1982) model does not actually
assume complete markets, and in fact can contain far more states of nature than assets. However,
other special assumptions made by Lucas result in an allocation the same as the one complete
markets would produce.
Except for cert ai n special cases, mar ket compl et eness requi res t hat peopl e
be abl e to t r ade as ma ny i ndependent assets as t her e are prospect i ve states
of nat ure. Equi val ent l y, t hey must be able t o t rade a compl et e set of Arrow--
Debr eu securities, each of which pays off onl y in one state. The result of this
t rade is t hat i ndi vi dual s everywhere in the worl d equal i ze t hei r margi nal rates
of subst i t ut i on of pr esent for f ut ur e st at e-cont i ngent consumpt i on to the same
Ar r ow- De br e u prices, so t hat for all count ri es i and j , and all dat es t,
u ' ( q + l ) ' J
u ( C t + 1 )
- ( 3 . 2 9 ,
u ' ( C / ) , , ' ( C / )
given shared rat es of t i me preference (that is, t he / % cancel). Condi t i on (3,29)
precl udes f ur t her mut ual gains, on any dat e or in any st at e, f r om i nt er-consumer
risk pooling. I nvest ment decisions are made to maxi mi ze the present val ue o~
profits eval uat ed at st at e-cont i ngent out put prices.
When all peopl e t hr oughout the worl d t rade prospect i ve risks in i nsurance
market s, some local economi ~ shocks effect i vel y become gl obal shocks and t hei r
current account effects are di mi ni shed or even el i mi nat ed. Consider, for in-
stance, a pure exchange economy t hat experi ences a t empor ar y i di osyncrat i c
posi t i ve out put shock. Absent i nsurance market s, t he count r y woul d run a
current -account surplus, accumul at i ng some forei gn assets so as to smoot h the
benefi t s of the shock over all fut ure periods. Under compl et e market s, however,
t he home economy has al r eady t r aded much of its out put risk to forei gners and
purchased, in t urn, claims on t hei r risky out put processes. Thus, t he home econ-
omy' s posi t i ve out put shock will cause a small synchroni zed i ncrease in every
count ry' s consumpt i on under compl et e market s. But it will also cause a shift in
ever y count ry' s i ncome as "di vi dend" payment s flow f r om the home count r y to
its forei gn sharehol ders. Wi t h i nt er nat i onal l y i dent i cal isoelastic preferences, no
current -account i mbal ances result. Indeed, in t hat case, t here are never unan-
t i ci pat ed current account movement s. (Regardl ess of t he ut i l i t y funct i on, dif-
ferences in t i me pr ef er ence can gener at e predi ct abl e nonzer o current accounts
under compl et e market s. )
If per i od ut i l i t y is not isoelastic and identical across count ri es, worl d out put
shocks will, in general , cause current -account i mbal ances. Even in this case,
shocks t hat affect t he di st ri but i on of out put across count ri es, but l eave worl d
out put unchanged, have no current -account implications.
Ret ur ni ng to t he case of i nt er nat i onal l y i dent i cal isoelastic ut i l i t y but in-
t roduci ng product i on, a positive shock to t he product i vi t y of domest i c invest-
ment causes a current -account deficit, as in our earl i er perfect -foresi ght models.
But t hat deficit will reflect onl y an influx of savings f r om abr oad to share in
ownershi p of the i ncr ement al i nvest ment . (Indeed, the existing capital of firms
will al r eady have a gl obal l y dispersed ownership. ) The deficit does not reflect
cons umpt i on- s moot hi ng effects, because all count r i es' i ncome profi l es are rising
in pr opor t i on. Des pi t e t he deficit - i ndeed, because of it - t he i nt er nat i onal
weal t h di st r i but i on is const ant .
Unde r l i t er al l y compl et e mar ket s, risks due t o changes in gover nment con-
sumpt i on also woul d be per f ect l y pool ed among nat i ons. An exogenous un-
expect ed rise in Uni t ed St at es spendi ng on hi ghway repai rs due, say, to bad
weat her , woul d be fi nanced most l y by cont i ngent - cont r act payment s f r om for-
ei gners t o t he Uni t e d States. The obvi ous adver se i ncent i ves i nt r oduced by such
cont r act s i l l ust r at e why, in pract i ce, asset mar ket s ar e har dl y compl et e. If a coun-
t ry' s r esi dent s have sold most of domest i c firms' f ut ur e earni ngs on f or war d mar-
ket s, its gove r nme nt has ever y i ncent i ve t o rai se cor por at e t axes sharpl y af t er
t he fact. Mor e general l y, under asymmet r i c i nf or mat i on, mor al hazar ds affect i ng
pr i vat e as wel l as gover nment behavi or i mpede compl et e risk sharing. I nf or mal
obs er vat i on and statistical evi dence bot h confi rm t hat even in a domest i c con-
t ext , risks are f ar f r om bei ng pool ed as t he compl et e- mar ket s par adi gm woul d
predi ct . In t he i nt er nat i onal cont ext , sover ei gn risk and di st ance, t oget her wi t h
cul t ural and l egal di fferences, gr eat l y magni f y t he difficulties. 3
3.2.2. Bonds as the onl y asset
Le t us l ook i nst ead at t he opposi t e ext r eme, t hat in whi ch t he onl y asset nat i ons
t r ade is a one- per i od bond i ndexed t o t r adeabl e cons umpt i on goods and of f er i ng
a cer t ai n one- per i od r et ur n. Thi s rest ri ct i on on t he me nu of assets is t oo sever e
t o furni sh a compl et el y real i st i c model , but it does serve t o pr oduce a model
qui t e compar abl e t o t he det er mi ni st i c one st udi ed earlier. La t e r on we discuss
hybr i d model s in whi ch t her e are mar ket s f or some, but not all, risks.
For simplicity, we agai n choose as our f r amewor k a r epr es ent at i ve- agent econ-
omy in whi ch all goods are t r aded. Now t he i ndi vi dual maxi mi zes t he condi t i onal
expect at i on
subj ect t o a budget const r ai nt like (3.5) equat i ng t he pr esent val ue of consump-
t i on t o initial financial weal t h plus t he pr esent val ue of aft er-t ax l abor i ncome.
The cons umpt i on levels in (3.30) are cont i ngency pl ans for cons umpt i on t hat
depend on t he i ndi vi dual ' s hi st ory t hr ough t he dat e t he pl an is i mpl ement ed.
The budget const r ai nt depends on st ochast i c f ut ur e earni ngs, taxes, and i nt er est
rat es. The sequence of cont i ngent cons umpt i on pl ans t he cons umer chooses on
3See Obsffeld (1995) for a survey of evidence. The limited extent of international risk sharing
has prompted Shiller (1993) to propose creating international markets in GDP futures.
date t must satisfy the budget constraint for every prospective history of the
economy.
The i nt ert emporal Eul er equation derived in the certainty case now holds in
expectation [cf. eq. (3.6)]:
u ' ( C t) / 3( i + r t + l ) E , ( 3 . 3 l )
To obtain closed-form consumer decision rules, we approximate u ( C ) by the
quadratic function
h C2
u( c ) - c -
With this approximation (3.31) becomes
1 1 ( /3(1+rf+1)1 )
E t Ct+ 1 = / 3 ( l + rt+l) Ct + -~ 1
Her e we see that the relation between /3 and the gross world interest rate
induces a tilt in expect ed consumption growth as was also true in Subsection
3.131 .
To simplify further, assume temporarily that the interest rate is constant at r,
with 13(1 + r) = 1; the result is the "random walk" prediction for consumption
derived by Hall (1978):
E t Ct+l = Ct (3.32)
In equilibrium, the economy' s intertemporal budget constraint, eq. (3.3), must
hold for every possible sequence of outcomes when its elements are random.
Applying the date-t expectations operat or to both sides of (3.3) and using (3.32),
we have the certainty-equivalence consumption function:
C, = 1-77r Et (1 + r ) A t + Z \ ] - 7 7 2 (Y~ - G , - l s ) (3.33)
S = t
Equat i on (3.33) yields predictions for current accounts qualitatively similar
to those of the deterministic consumption function (3.8) devel oped earlier. As a
result, this equation and its relatives provide the leading vehicles for empirical
studies of current-account determination. The linear-quadratic formulation has,
however, at least t hree conceptual drawbacks:
31In t he precedi ng equat i on t he ratio of t he gross i nt erest rat e to 1/13 ent ers bot h in the slope and
in t he i nt ercept , with opposite effects on expect ed dat e@ + 1) consumption. The quadrat i c utility
specification makes sense, however, only so long as C < 1/ h, ensuring t hat t he margi nal utility
of consumpt i on is positive. Under this assumption, it is clear t hat t he i nt ercept effect dominates:
l oweri ng/ 3, for example, lowers expect ed dat e-(t + 1) consumpt i on in t he last equation.
1768 M. Obstfeld and K. Rogo]f
(1) Un d e r quadr at i c ut i l i t y u"~( C) ~- O, so t her e is no pr ecaut i onar y saving.
When, i nst ead, u"~( C) > 0, margi nal ut i l i t y d ( C ) is a convex funct i on. Thi s
convexi t y i mpl i es t hat an i ncrease in uncer t ai nt y over f ut ur e cons umpt i on rai ses
its expect ed mar gi nal ut i l i t y and, thus, saving. 32
(2) In bot h est i mat i ng and si mul at i ng i nt er t empor al model s, it is f r equent l y
conveni ent t o be able t o l i neari ze or l og-l i neari ze fi rst -order Eul e r condi t i ons.
Assumi ng quadr at i c per i od ut i l i t y is r eal l y just anot her way of linearizing. The
basi c pr obl em wi t h this appr oach is t hat a l i near i zed model will be ver y i naccu-
r at e far away f r om t he poi nt of appr oxi mat i on. Yet if t he l i near i zat i on implies,
as in (3.32), t hat consumpt i on follows a r a ndom wal k, consumpt i on will event u-
ally dri ft ar bi t r ar i l y far f r om any initial level. As Obst f el d (1982) and Svensson
and Razi n (1983) showed, one way t o avoi d a uni t r oot in cons umpt i on is t o
assume an endogenous, r at her t han fixed, r at e of t i me pr ef er ence. If t he r at e
of i mpat i ence rises wi t h t he l evel of consumpt i on, a st at i onar y cons umpt i on
di st r i but i on is possible. Unde r uncert ai nt y, pr ecaut i onar y saving can mi mi c this
behavi or ( even wi t h a fixed t i me- pr ef er ence r at e) because consumer s save less at
hi gher weal t h levels. [See Car r ol l (1992) and De a t o n (1992).] Anot he r sol ut i on
is t o assume over l appi ng cohor t s of fi ni t e-l i ved agent s who l eave no bequest s.
Unf or t unat el y, no al t er nat i ve can mat ch t he l i near - quadr at i c i nfi ni t e-l i fet i me
f r amewor k f or easy empi ri cal i mpl ement at i on. Ul t i mat el y t he j ust i fi cat i on f or
usi ng t he l at t er set up must rest on t he pr es umpt i on t hat it yi el ds a r eas onabl e
appr oxi mat i on t o behavi or away fi' om boundar i es. Mor e r esear ch pr ovi ng or
di spr ovi ng this pr es umpt i on woul d be useful. 33
(3) The cons umpt i on f unct i on (3.33) does not necessari l y const r ai n consump-
t i on t o be non- negat i ve in all states of t he worl d. I f negat i ve l evel s of consump-
t i on are r ul ed out , consumpt i on cannot l i t eral l y f ol l ow a r andom wal k as in
(3.32) .34
We t ur n next t o i nvest i gat i ng how, when bonds ar e t he onl y i nt er nat i onal l y
t r aded asset, t he separ at i on bet ween domest i c i nvest ment and consumpt i on i m-
pl i ed by compl et e mar ket s can br eak down.
It is nat ur al t o assume agai n t hat t he domest i c firm makes its i nvest ment
deci si on on dat e t t o maxi mi ze t he pr esent di scount ed val ue of profits. But wi t h
uncer t ai nt y, it is no l onger obvi ous what di scount r at e shoul d be used t o val ue
t he ri sky st r eam of di vi dends t he firm issues t o sharehol ders. Wi t h popul at i on
nor mal i zed t o 1, t he firm' s e x d i v i d e n d val ue, Vt+l, is t he pri ce of a per capi t a
32On precautionary saving behavior, see Leland (1968).
33Clarida (1990) develops an exact general-equilibrium model of international borrowing and
lending under endowment uncertainty, heterogenous fixed discount rates, and lower limits on in-
dividual assets. He finds that when there is no aggregate output uncertainty, there is a stationary
distribution of wealth and consumption levels in which some households are borrowing-constrained.
34The problem of nonnegativity constraints afflicts the commonly used consumption functions
derived in continuous-time models by stochastic dynamic programming. See Cox and Huang (1989).
Ch. 34: The l nt ert emporal Approach to the Current Account 1769
s har e i n t he fi rm i n d a t e t asset t r adi ng. Us i n g d y n a mi c p r o g r a mmi n g ( t h e d e t a i l s
a r e o m i t t e d h e r e ) , o n e c a n s how t hat Vt +l f ol l ows a s t oc ha s t i c pr oces s such t hat
t he f ol l owi ng Eu l e r e q u a t i o n hol ds:
V t + l U' ( C t ) = f l E t { [ O t + l V ( K t + l , Lt +l ) - Wt +l Lt +l
- I t + l - a I { +l / Z Kt +l + Vt +2 ] u ' ( Ct +l ) }
I t e r a t e d f o r wa r d s ubs t i t ut i ons f or V yi el d a s t ochas t i c ve r s i on of (3. 16),
O s F ( K s , L s ) - w~. Ls - Is - 2-~sJ (3.34)
Gi v e n t ha t t he f i r m is o wn e d e nt i r e l y by d o me s t i c r es i dent s , t he pr e s e nt val ue
of a cl ai m t o its f ut ur e di vi dends i n a ny pa r t i c ul a r s t at e of n a t u r e d e p e n d s on
d o m e s t i c c o n s u me r ' s ma r g i n a l ut i l i t y i n t hat st at e of n a t u r e r el at i ve t o c ur r e nt
ma r g i n a l utility.
We c a n d e c o mp o s e (3. 34) f ur t he r as 3s
s = t + l b l t ( C t ) E t O s F ( K s , L s ) - w s L s - I s - 2 K ,
+ f i s - t C o v t u~- 7~t ) , O s X ( K s , Ls ) - w s L s - Is,. - 2Ks.---
S=t+]
De f i n e R L t o be t he ma r k e t di s c ount f a c t or b e t we e n pe r i ods t and s , t hat i s ,
t,s
t he pr i ce of s ur e ( t hat is, n o n c o n t i n g e n t ) da t e s c o n s u mp t i o n i n t er ms of da t e
t c o n s u mp t i o n . Of cour s e, R L is s i mpl y t he i nver s e o f t he gr oss s hor t r at e,
t,t+l
1 + rt+1.36 Th e (s - t ) - p e r i o d a na l og o f eq. (3. 31) is
s - t L
. ' ( c , ) = / R t , ) E t
so t he p r e v i o u s e q u a t i o n can be wr i t t e n as
o~ { a / 2 . ~
Vt +l = ~ R L , . E t Os F ( K ~ , L s ) - w s L s - I s - 2 K~ J
s~t+]
+ f l , _ t C o v t ( , u ' ( C s ) O s F ( K s , L s ) - w s C s - I s - 2 K s
s : , + l I ,
35The result below uses the fact that if X and X ~ are two random variables, E(XX/)
E(X)E(X ~) + C o v ( X , X t ) .
36In a deterministic model, R~s = Rt,s as defined in eq. (3.2). The equality breaks down here
because future short rates are stochastic, whereas R~s is known on date t.
1770 M. Obstjeld and K. Rogoff
Equat i on (3.35) shows t hat t he firm' s val ue is t he convent i onal present val ue
of di vi dends plus a risk premi um: t he firm is val ued mor e hi ghl y if it pays out
unexpect edl y hi gh di vi dends when the margi nal ut i l i t y of owners' consumpt i on
is unexpect edl y high. The presence of a risk pr emi um i nt roduces an addi t i onal
channel t hr ough which shifts in consumpt i on pr ef er ences can influence invest-
ment behavior.
The firm' s i nvest ment behavi or can be charact eri zed by maxi mi zi ng t he sum
of current profits and (3.34) subject to (3.12). As in t he det ermi ni st i c case cur-
r ent i nvest ment is governed by (3.13), where qt = V~+I/Kt+I and Vt+l is given
by (3.34). The resul t is a ri cher q model of i nvest ment with current -account
predi ct i ons similar to t hose of Section 3.1. 37
3.2.3. Partially complete markets
In real i t y count ri es t rade not onl y bonds but a rich menu of assets, includ-
ing equi t y shares, cur r ency- denomi nat ed i nst rument s, and ot her securities wi t h
st at e- cont i ngent payoffs. Thi s t rade ensures t hat some, if not all, consumpt i on
risks can be pool ed and t hat the current -account effect s arising in t he last set
of model s will be mut ed.
Equat i on (3.31) implies t hat whenever t here is free t rade in noncont i ngent
bonds bet ween t wo count ri es i and j, t he expect ed growt h rates of t hei r resi-
dent s' mar gi nal utilities f r om consumpt i on are equal , assumi ng a common rat e
of t i me preference. Thus,
{ } { }
,
u ( c , + 1 ) = E , ( 3 . 3 6 )
E, u'(C[) u'(C{)
Unde r compl et e mar ket s [see eq. (3.29)], this equat i on holds ex post, not j ust
in expect at i on. When onl y (3.36) holds, however, di fferences in margi nal rat es
of i nt er t empor al subst i t ut i on can occur aft er t he fact.
When some, but not all, risks can be t r aded bet ween countries, consump-
t i on behavi or will be i nt er medi at e bet ween the predi ct i ons of (3.29) and (3.36).
Specifically, (3.29) predicts t hat margi nal rat e of i nt er t empor al subst i t ut i on dif-
ferences do not arise, while (3.36) predicts t hese di fferences can arise unexpect -
edly. In t he i nt er medi at e case, the ex post di fference
t i
u ' ( C / ) . ' ( c j )
will be condi t i onal l y uncor r el at ed wi t h any da t e - ( t +l ) r andom vari abl e on which
37See, for example, Baxter and Crucini (1993b) and Glick and Rogoff (1995).
contingent contractual payments can be conditioned. Thus, if Xt+l is a random
variable on which contracts can be written prior to date t + 1,
u ( c , + 1 ) , x , + l = 0 (3. . 37)
C o v , u ' ( C / ) u ' ( C l )
For example, if people in different countries can effectively pool the idiosyn-
cratic consumption risks due to nominal exchange-rate fluctuations through for-
eign exchange market deals, then realized exchange rate fluctuations will be sta-
tistically unrelated to international differences in the growth of u/(C).3~ Because
it is only partial, however, such insurance dearly leaves scope for unexpected
current-account movements.
Svensson (1988) develops a two-period model in which period 1 asset trading
serves to pool consumption risks for period 2. Svensson shows that the usual
logic of trade theory can be extended to analyze not only the current account
under uncertainty, but also the asset composition of gross capital flows between
countries. He develops a two-period pure exchange model of international trade
in a possibly incomplete set of risky assets. In that model, a multi-commodity
comparative advantage principle applies [see Dixit and Norman (1980), p. 95]:
the inner product of a country's net asset import vector with the vector of home
mi n u s foreign autarky asset prices is positive.
When countries trade equity shares as well as noncontingent bonds, the sep-
aration between domestic investment and consumption may still obtain even
though asset markets are incomplete. As (3.37) shows, domestic and foreign
residents must attach the same values to the state-contingent profits of a firm
that they trade. A sufficient condition for the separation property to hold is that
investment decisions themselves do not change these common valuations [see
Ekern and Wilson (1974)].
3.2.4. E n d o g e n o u s ma r k e t i nc ompl e t e ne s s
We have seen that some of the model's predictions concerning current account
behavior depend critically on the structure of asset markets and in particular the
degree to which complete markets prevail. We have argued that the complete
markets model is inadequate empirically, but if so it would be helpful to have
a deeper understanding of the frictions that impinge on market completeness,
rather than just assuming market limitations exogenously.
In this section we present an example, drawn from Gertler and Rogoff (1990),
of how international capital flows behave in the presence of moral hazard de-
riving from asymmetric information at the microeconomic level. A key insight
38For a formal derivation, see Obstfeld (1994).
f r om the model , which carries over t o ot her settings, is t hat i nt er nat i onal asset
mar ket s can bri ng the global al l ocat i on of resources part of t he way, but onl y
par t of t he way, t oward t he ful l -i nformat i on opt i mum. Thus, t he i nt er t empor al
approach, as sket ched above, may well get t he d i r e c t i o n s of net i nt er nat i onal
capital flows ri ght while overst at i ng magni t udes.
We now adopt a t wo-peri od, single good set up in whi ch each of t he numer ous
at omi st i c resi dent s of a small count ry maxi mi zes
u ( c l , c 2 ) = G ( 3 . 3 8 )
gi ven exogenous endowment s E1 of t he consumpt i on good in per i od i and E2
in peri od 2. The utility funct i on (3.38) is obvi ousl y ver y special (clearly C1 = 0
is opt i mal ) but it allows us to simplify the analysis whi l e still maki ng our mai n
points. The focus, i nst ead, is on i nvest ment . Each resi dent has two ways to
t r ansf or m E1 i nt o fut ure consumpt i on. He or she may l end in t he worl d capi t al
mar ket and ear n a riskless net rat e of r et ur n r. Al t ernat i vel y, current resources
can be i nvest ed in a risky domest i c project. If a r esi dent invests K in per i od 1,
t hen t he proj ect ' s stochastic payof f in per i od 2 is Y, where
4' > 0 wi t h probabi l i t y or(K)
Y = 0 wi t h probabi l i t y 1 - ~r(K)
Above, ~-(K) is increasing, strictly concave, and twice cont i nuousl y di fferen-
tiable, wi t h ~r(0) = 0, 1r(oo) = 1, and 1 + r < 4'~-~(0) < ec. These assumpt i ons
ensure t hat hi gher i nvest ment increases t he l i kel i hood of a successful out come
(but at a di mi ni shi ng rat e) and t hat the prospect of success woul d j ust i fy nonzer o
i nvest ment under symmet r i c i nformat i on. Ever y i ndi vi dual has one pot ent i al in-
vest ment proj ect and di f f er ent i ndi vi dual s' i nvest ment out comes are statistically
i ndependent .
In this model , t he opt i mal ful l -i nformat i on i nvest ment level is K*, defi ned by
~-'(K*)4' = 1 + r (3.39)
At this poi nt , t he margi nal ret urn to investing equal s the r et ur n t hat can be
ear ned t hr ough l endi ng abroad. Let us assume t hat
Ez K*
E J + l + r <
Thi s i nequal i t y implies t hat each resi dent needs to borrow a positive amount
f r om forei gners to be able to invest optimally. Fur t her mor e, t he condi t i on is
equi val ent to t he i nequal i t y E2 < (1 + r ) ( K * - E l ) , which states t hat it is in-
feasi bl e for l enders to finance the i nvest ment level K* t hrough a risk-free loan.
If an i nvest ment project fails, even t he borrower' s ent i re peri od 2 endowment
is insufficient to repay l enders (1 + r ) ( K * - E l ) . Thus, l oan cont ract s t ake t he
f ol l owi ng, s t a t e - c ont i nge nt , f or m: i n r e t ur n f or a l oan o f si ze L in p e r i o d 1, t hc
b o r r o we r p r o mi s e s t o r e p a y Zg i n pe r i od 2 i n t he e v e n t his o r her i n v e s t me n t
is successf ul a n d Z b < z g i n t he e ve nt it fails. Le n d e r s ar e c o mp e t i t i v e and do
not of f e r a l oa n c o n t r a c t unl ess its e xpe c t e d gr os s r e t ur n equal s 1 + r :
~ r ( K ) Z g + [1 - ~r ( K) ] Z/ ' = (1 + r ) L (3. 40)
Th e pr ovi s i ons o f l oa n c ont r a c t s ar e a s s u me d t o be f ul l y e nf or c e a bl e .
Th e mo r a l h a z a r d p r o b l e m unde r l yi ng t he mo d e l ar i ses f r o m its i n f o r ma t i o n
s t r uct ur e. Le n d e r s o b s e r v e a b o r r o we r ' s e n d o wme n t s a nd t he o u t p u t of t he
i n v e s t me n t pr oj e c t ( t hat is, wh e t h e r t he pr oj e c t is successf ul o r not ) ; of cour s e,
t h e y al so k n o w t he si ze o f t he l oan. Th e y c annot , howe ve r , ve r i f y t he l evel of
i nve s t me nt , K. Thus , b o r r o we r s c a nnot c o mmi t t he ms e l ve s t o a ny speci fi c l evel
o f i n v e s t me n t b y wr i t i ng pr omi s e s a b o u t K i nt o t he l oa n cont r act . Fo r e xa mpl e ,
t he r e is n o wa y l e nde r s can p r e v e n t b o r r o we r s f r o m i nves t i ng n o t h i n g at all and
i ns t e a d s ecr et l y pl a c i ng all of t hei r r es our ces , b o r r o we d as wel l as n o n b o r r o we d ,
i n f or e i gn asset s ( an a c t i on r e mi ni s c e nt o f " c a pi t a l f l i ght ") . But i f b o r r o we r s do
so, t he r e is no c ha nc e t hei r pr oj ect s wi l l s ucceed. Th e i n f o r ma t i o n a l a s y mme t r y
a l l owi ng t hi s ki nd o f b e h a v i o r l eads t o i nef f i ci ent i n v e s t me n t and b o r r o wi n g
l evel s, as we now show. 39
Gi v e n t he avai l abl e l oa n c ont r a c t , a t ypi cal b o r r o we r ma xi mi z e s e x p e c t e d
s e c ond p e r i o d c o n s u mp t i o n
E{ C2} = ~( K) ( q5 - Z ~') - [1 - ~r ( K) ] Z b + (1 + r ) ( E l + L - K ) + E2 (3. 41)
s ubj ect t o t he c ons t r a i nt
E1 + L _> K (3. 42)
Co n s t r a i n t (3. 42) doe s n o t bi nd wh e n t he b o r r o we r is s ecr et l y i nves t i ng re-
s our ces a b r o a d r a t h e r t ha n at h o me . Th e ne c e s s a r y Ku h n - T u c k e r c ondi t i ons
f or a ma x i mu m ar e:
zr/(K)[q5 - ( Z g - ZI ' ) ] = 1 + r + h (3. 43)
A > 0, A(E1 + L - K) = 0 (3. 44)
Co n d i t i o n s (3. 43) and (3. 44) i mpl y t ha t e ve n a b o r r o we r wi t h access t o a l oan
L l ar ge e n o u g h t o p e r mi t t he des i r ed i n v e s t me n t l evel ( so t ha t h = 0) pi cks a
K t ha t sat i sfi es
39If borrowers could commit to invest K*, lenders would break even by lending them L = K* - El
and setting Z l~ = E2, z g = (1 + r) [K* - E1 - (1 - ~r(K*))E2J/Tr(K*). [Because ~-(K) is strictly
concave and ~r(0) = 0, Zg < ~b + E2.] In this model, there is an implicit assumption that foreign
direct investment cannot substitute perfectly for lending; that is, foreigners cannot circumvent the
agency problem by purchasing investment opportunities in the borrowing country and exploiting
them optimally themselves. This assumption could be justified by a threat of nationalization, or
simply by a comparative informational advantage of local residents in finding suppliers, monitoring
workers, greasing the collective palm of local officialdom, etc.
~v'(K)[4, - ( Z g - zb) ] = 1 + r (3.45)
and, thus, is st ri ct l y below t he f ul l - i nf or mat i on opt i mum l evel descr i bed by eq.
(3.39). The r eason is t hat t he change in payof f t o t he bor r ower when a pr oj ect
succeeds is
4 , - z ~ - ( - z I , ) = 4 , - ( z ~ ' - z ~ ) < 4 ,
Al t hough l ender s cannot obser ve K directly, t hey have r at i onal expect at i ons
and t hus can fi gure out t he l evel of K bor r ower s will choose f or a gi ven l oan con-
tract. The y t her ef or e of f er a l oan cont r act such t hat t he K t he bor r ower chooses,
gi ven L, z g, and Z b, satisfies t he r equi r ed r at e of r et ur n condi t i on (3.40). Com-
pet i t i on among l ender s ensur es t hat this cont r act is opt i mal f or t he bor r ower ,
subj ect t o t he const rai nt s ment i oned. Formal l y, t he opt i mal i ncent i ve- compat i bl e
cont r act (L, z g, Z ~) maxi mi zes E{C2} subj ect t o (3.40), (3.42), (3.45), and t he
i nequal i t y Z b < E2.
The opt i mal cont r act satisfies Z b = E2 (so as t o mi ni mi ze t he gap ;~ - Z g- Z b
and, thus, t he gap bet ween K and K*). 4 Fur t he r mor e , t he cont r act satisfies
(3.42) wi t h equal i t y: i ncreasi ng L above K - E1 woul d force a rise in z g and,
wi t h it, a wor seni ng in i nvest ment i ncent i ves. Combi ni ng t hese facts wi t h t he
i ncent i ve- c0mpat i bi l i t y const r ai nt (3.45) and t he l ender s' zer o- pr of i t condi t i on
(3.40), we see t hat t he opt i mal cont r act is t he sol ut i on to t he t hr ee- equat i on
syst em
~ ' ( K ) ( 4 , - 2 ) = ~ + r
2 = (1 + r ) K - E,, - T T ; r / ~ ( K)
L =K- E1.
Thi s sol ut i on has a numbe r of i mpor t ant i mpl i cat i ons:
(1) The i ncent i ve- compat i bl e i nvest ment l evel is bel ow t he f ul l - i nf or mat i on
opt i mum of (3.39). Accordi ngl y, per i od 1 capi t al inflows are bel ow t he l evel a
f ul l - i nf or mat i on model woul d predi ct .
(2) An i ncr ease in t he pr oduct i vi t y par ame t e r 4, i ncreases t he per i od 1 capi t al
inflow and i nvest ment level, but it also wi dens t he spr ead Z, bet ween t he good-
and bad- out come l oan payment s. Thus, ( under mi l d rest ri ct i ons on ~-(K)) t he
resul t i ng capi t al inflow is less t han in t he f ul l - i nf or mat i on case.
(3) The expect ed margi nal pr oduct of capital, ~r~(K)4,, exceeds t he wor l d
( and domest i c) riskless i nt er est rat e, 1 + r.
(4) An i ncr ease in ei t her endowment , E1 or E2, raises i nvest ment by l ower i ng
Z. In t he first case this ef f ect is due t o a l esser r el i ance on ext er nal funds, in
4See Gertler and Rogoff (1990) for details.
t he second to t he possi bi l i t y of a l ar ger l oan pa yme nt in t he bad- out come state.
The i nvar i ance of i nves t ment wi t h respect t o i nt er t empor al pr ef er ences t hat
char act er i zed t he si ngl e-sect or model s descr i bed ear l i er need not hol d when
i nves t ment is subj ect t o mor al hazard. 41
In a t wo- count r y gener al equi l i br i um ver si on of t he model , one can show t hat
endogenous di f f er ences in capi t al mar ket i mper f ect i ons can dr amat i cal l y r educe
t he flow of capi t al f r om rich t o poor count ri es, and even r ever se it [see Ger t l cr
and Rogof f (1990)].
The pr ecedi ng model has abst r act ed bot h fron~t t he cons umpt i on smoot hi ng
mot i ve behi nd t he cur r ent account and f r om t he bor r ower s ' desi re to engagc
in asset t r ades t hat r educe t he uncer t ai nt y of second- per i od consumpt i on. It is
st r ai ght f or war d t o add second- per i od risk aversi on t o t he model by assumi ng
t hat (3.38) is r epl aced by
h 2
u ( C1 , C~) = C2 - ~ C 2
In or der t o focus on t he new issues t hat arise, it is conveni ent t o suppose l hat
E1 _> K*. In this case, domest i c resi dent s' e ndowme nt is l arge enough so t hat
t hey have no ne e d t o bor r ow t o fi nance i nvest ment , and t hei r onl y mot i ve f or
t appi ng t he i nt er nat i onal capi t al mar ket is t o i nsure per i od 2 consumpt i on. He r e
agai n we have a mor al hazar d pr obl em because nonver i f i abl e i nvest ment deci-
sions affect t he pr obabi l i t y di st ri but i on of second- per i od out put . It can be shown
t hat under t he opt i mal i ncent i ve- compat i bl e cont ract , cons umpt i on i nsurance
will be par t i al and K will be bel ow K*. 42
The gener al concl usi on is t hat asymmet r i c i nf or mat i on need not cause finan-
cial mar ket s to br eak down entirely. Inst ead, financial mar ket s may do onl y
par t i al l y t he j ob t hey coul d do in a wor l d of full i nf or mat i on. Not e also t hat
in t hi nki ng about t he i ncompl et eness of mar ket s, it ma y be mi sl eadi ng t o t hi nk
of risks as bei ng ei t her i nsur abl e or noni nsur abl e. In ma ny cases, t hr ough what
is basi cal l y a coi nsur ance mechani sm, s o m e gains f r om t r ade across states of
nat ur e will be r eal i zed even under mor al hazard. 43 The same poi nt appl i es to
t r ade across t i me.
We have f ocused on capi t al - mar ket i mper f ect i ons arising f r om asymmet r i c
i nf or mat i on at t he mi cr o level. Anot he r ver y i mpor t ant cause of i nt er nat i onal
capi t al - mar ket i mper f ect i on is sover ei gn def aul t risk at t he macr o level. Sovcr-
ei gn risk need not be r el at ed t o asymmet r i c i nf or mat i on, but can have qual i t a-
41It is agai n easy to see t hat Zg < q~ + E 2.
42See Obst fel d and Rogoff (1996), ch. 6.
43The implications of adverse selection probl ems can be quite different, al t hough we do not
consider t hem here. At keson and Lucas (1992) study a different moral hazard probl em, one m
which peopl e (or countries) wish to insure against preference shocks. They find t hat under optimal
i ncent i ve-compat i bl e ar r angement s, t he degree of consumpt i on inequality in t he world increases
continually.
t i vel y si mi l ar i mpl i cat i ons. 44 J ona t ha n Ea t on and Ra que l Fer nandez pr es ent a
det ai l ed anal ysi s of t he effect s of s over ei gn ri sk in t hei r chapt er in this Ha n d -
book. A c o mmo n t heme in sover ei gn- r i sk model s is t hat t he cons umpt i on-
s moot hi ng and r i sk- shar i ng rol es of i nt er nat i onal capi t al ma r ke t s still oper at e,
but ar e t e mp e r e d by def aul t risk.
4. Empirical evi dence oll t he i ntertemporal approach
The i nt e r t e mpor a l appr oach t o t he cur r ent account has been subj ect ed to ext en-
si ve f or ma l t est i ng; much of t he me t hodol ogy used gr ows out of Hal l ' s (1978)
s emi nal wor k on t he i mpl i cat i ons of t he r at i onal - expect at i ons as s umpt i on f or
f or war d l ooki ng cons umpt i on t heori es. A less f or ma l empi r i cal met hodol ogy,
pi one e r e d by Fel dst ei n and Ho r i o k a (1980), has be e n used t o ar gue t hat t he
cl ose r el at i ons hi p be t we e n nat i onal savi ng and i nve s t me nt r at es in pos t - Wor l d
Wa r I I dat a f ur ni shes a pri ma facie case agai nst t he pr act i cal r el evance of t he
i nt e r t e mpor a l appr oach. The s e t wo r es ear ch avenues ar e cl osel y i nt er t wi ned, as
any a t t e mpt t o r econci l e t he Fe l ds t e i n- t t or i oka fi ndi ngs wi t h t he i nt e r t e mpor a l
a ppr oa c h rest s on t he val i di t y of model s such as t hose s ur veyed in Sect i on 3. 45
4.1. The relationship between national savi ng and domest i c i nvest ment rates
I n a cl osed economy, nat i onal savi ng equal s domes t i c i nves t ment and t he cur-
r ent account is al ways zero. Fur t he r mor e , any obs e r ve d i ncr ease in nat i onal
savi ng will aut omat i cal l y be accompani ed by an equal ri se in domes t i c i nvest -
ment . A basi c pr e mi s e of t he i nt e r t e mpor a l a ppr oa c h is t hat capi t al is to s ome
de gr e e i nt er nat i onal l y mobi l e, so t hat cur r ent account i mbal ances ar e a pos-
sibility. Gi v e n t hi s pr emi se, t he i nt e r t e mpor a l a ppr oa c h pr edi ct s a n u mb e r of
si t uat i ons in whi ch di ver gences be t we e n savi ng and i nves t ment will arise. An
empi r i cal fi ndi ng t hat nat i onal savi ng r at es af f ect domes t i c i nves t ment r at es
wi t h uni t coeffi ci ent s woul d t her ef or e a ppe a r t o be st r ong evi dence agai nst t he
appl i cabi l i t y of t he i nt e r t e mpor a l appr oach.
Fel dst ei n and Ho r i o k a (1980), in t he first of a seri es of r el at ed paper s by
Fel dst ei n and coaut hor s, ar gued t hat capi t al mobi l i t y is suffi ci ent l y l i mi t ed, at
44Atkeson (1991) presents an interesting analysis incorporating both asymmetric information and
sovereign risk.
45We do not survey the methodology of calibrating open-economy models with incomplete mar-
kets so as to match moments of actual aggregate data. Interesting recent work along this line,
exemplified by Baxter and Crucini (1993b) and Kollmann (1992), is discussed in Marianne Baxter's
chapter in this Handbook. We also refrain from more than a brief and highly selective account of
the copious literature on measuring international capital mobility. See Frankel (1993) and Obstfeld
(1995) for recent surveys.
Ch. 34: The l nt ert emporal Approach to the Current Account
0.33
0.30
0.27
0.24
0.21
0.18
0.15
0.12
0.12 0.15
J A P
F I N P O R N O R
A U S
N Z A U T
I R E
= S P A
I C E I T A
G E R
Q . E " c A . " " F . . "
N E T
D E N - S W E
U S A
B E L
U K
%,
0. 18 0.21 0. 24 0. 27 0. 30 0. 33
S/Y
Figure 4. l . Saving and i nvest ment averages, t982-1991 (as a fraction of GDP).
1777
least over long horizons, that changes in national saving rates ultimately feed
through fully to domestic investment rates. As evidence, they reported cross-
sectional regressions of gross domestic investment rate averages ( I / Y ) on gross
national saving rate averages ( S / Y ) . These ratios of nominal flows, of course,
suffer from all the conceptual deficiencies discussed at the end of Section 2. For
a sample of 16 OECD countries over 1960-74, Feldstein and Horioka found
that:
( l / Y ) j ~- 0 . 0 3 5 + O. 8 8 7 ( S / Y ) j + uj ; R 2 = 0.91
(0.018) (0.074)
Feldstein and Bacchetta (1991) report similar results for a 1974-86 sample of
23 OECD members. Figure 4.1 shows the cross-sectional saving-investment as-
sociation in the OECD sample over the decade 1982-91, with Luxembourg,
which is an outlier, omitted. The estimation result for this sample, leaving out
developing Turkey, is:
( I / Y ) j = 0.088 + 0 . 6 2 2 ( S / Y ) y + uy; R 2 -~- 0.69
(0.020) (0.094)
This equation shows a weakening, but still very significant, positive association.
Feldstein and his collaborators argue that if capital indeed were highly mobile
among countries, slope coefficients like the one above should be much smaller
than 1, as a country's savings would then be free to seek out the most produc-
tive investment opportunities worldwide. Although the intertemporal approach
is consistent with a world in which changes in saving behavior impinge on do-
mest i c i nvest ment , it cer t ai nl y does not suppor t t he pol i cy concl usi on, pr ef er r ed
by Fel dst ei n, t hat gover nment measur es t o rai se a count r y' s saving r at e will
aut omat i cal l y cause a l ong-run pari passu i ncr ease in its i nvest ment rat e.
I f capi t al is t r ul y i mmobi l e and t he i nt er t empor al appr oach i r r el evant , how-
ever, t hen t he t i me- ser i es r el at i onshi p bet ween i ndi vi dual count r i es' saving and
i nves t ment rat es, l i ke t he cross-sect i onal r el at i onshi p among l ong savi ng and
i nves t ment aver ages, also shoul d be dose. We can t hi nk of t he t i me-seri es rel a-
t i onshi p among cont empor aneous det r ended saving and i nvest ment r at es as cap-
t ur i ng t he coher ence of hi gh- f r equency changes, whi l e t he Fe l ds t e i n- Hor i oka re-
gressi on capt ur es t he associ at i on bet ween l ow- f r equency or "sust ai ned" changes.
I ndeed, it is har d t o see how capi t al coul d be t r ul y i mmobi l e in t he l ong run
but not in t he shor t run, since t he long r un is just a successi on of shor t runs.
An d even if i nt er nat i onal t r ade in l ong- t er m i nst r ument s or l ong-l i ved assets
wer e hi ghl y l i mi t ed - a hypot hesi s t hat t he dat a do not suppor t - shor t - t er m
i nst r ument s can be r ol l ed over.
Th e t i me- ser i es and cross-sect i on aspects of t he s avi ng- i nves t ment r el at i on-
ship are qui t e distinct: t he t i me-seri es r el at i onshi p coul d be close and t he cross-
sect i on r el at i onshi p not , or vice versa. An exampl e is pr ovi ded by t he Uni t ed
Ki ngdom dur i ng t he pr e- Wor l d War I gol d st andar d ( Fi gur e 2.1). It is appar ent
t hat t he shor t - r un savi ng- i nvest ment cor r el at i on is ver y close. 46 Nonet hel ess,
t he U. K. r an cur r ent - account surpluses appr oachi ng 10 per cent of GDP in this
same per i od.
It is a "st yl i zed fact ", somewhat sensi t i ve t o t he det r endi ng me t hod adopt ed,
t hat t he t i me- ser i es savi ng- i nvest ment cor r el at i on is fai rl y st rong in r ecent data.
( See Fi gur e 2.3 f or some i ndust r i al - count r y dat a, but t her e are except i ons, t he
most gl ari ng of whi ch is Nor way wi t h its hi ghl y negat i vel y cor r el at ed saving
and i nves t ment rat es. ) For t he OECD count r i es i ncl udi ng Luxe mbour g but ex-
cl udi ng Tur key, t he aver age cor r el at i on bet ween saving and i nvest ment rat es is
0.495 over 1974-90 af t er l i near t i me det r endi ng. The cor r el at i on is 0.512 when
t he dat a are f i r st - di f f er enced to r emove t rend.
Eve n in a wor l d of compl et e capi t al mobi l i t y t hough, such cor r el at i ons are not
necessar i l y surpri si ng and can easi l y be expl ai ned on t he basis of t he i nt er t em-
por al appr oach. For exampl e, t he discussion of gr adual capi t al - st ock adj ust ment
in Sect i on 3 i mpl i es t hat a shock t o t ot al f act or product i vi t y, if short -l i ved but not
compl et el y t ransi t ory, raises saving as well as i nvest ment . Baxt er and Cruci ni
(1993a,b) and Mendoza (1991) (t he l at t er in a smal l - count r y setting, t he for-
me r in a gl obal - economy setting) have shown t hat i nt er t empor al mobi l e- capi t al
model s based on i nvest ment - adj ust ment costs can easi l y pr oduce t i me- ser i es
savi ng- i nvest ment cor r el at i ons at least as l arge as t hose in t he dat a. Par t of
t he mechani s m under l yi ng t he Baxt er - Cr uci ni findings is al l owance f or gl obal
46See Obstfeld (1986) for a more detailed statistical analysis of the U.K. data.
Ch. 34: The Interternporal Approach to the Current Account 1779
economi c shocks, whi ch obvi ousl y will i nduce positive savi ng-i nvest ment corre-
lations.
We have been focusi ng on time-series evi dence, but Fel dst ei n and Hor i oka' s
cross-sectional findings can also be rat i onal i zed by the presence of common
factors t hat mi ght si mul t aneousl y influence count ri es' saving and i nvest ment
rates.
It seems l i kel y t hat of t he many pot ent i al expl anat i ons of t he Fel dst ei n-
Hor i oka results, no single one fully explains t he behavi or of all countries. Taken
t oget her, however, and combi ned wi t h ot her evi dence i ndi cat i ng subst ant i al in-
t er nat i onal mobi l i t y of capital, t he ar gument s bel ow suggest t hat t he Fel dst ei n-
Hor i oka finding provi des no basis at all for dismissing the basic premi ses of the
i nt er t empor al approach:
(1) Even post-1973, gover nment s have somet i mes adj ust ed fiscal or monet ar y
policies to avoi d l arge and pr ot r act ed current -account i mbal ances. The evi dence
on this current -account t arget i ng hypot hesi s is most l y anecdot al , however, and
t her e are of course pr omi nent instances (like t he Uni t ed St at es in t he 1980s) in
whi ch macr oeconomi c policies have i nst i gat ed maj or ext ernal i mbal ances. 47
(2) OECD count ri es may be sufficiently well endowed wi t h capital to have
r eached stochastic st eady states for t hei r ext ernal debt or asset levels. In this
si t uat i on t he i nt er t empor al budget const rai nt of t he economy woul d i mpl y t hat
l ong averages of savi ng-i nvest ment di fferences are small. Devel opi ng count ri es,
which pr esumabl y coul d real i ze great er gains from i nt er t empor al t r ade t hr ough
borrowi ng for i nvest ment purposes, are l i kel y to be mor e di st ant f r om a sta-
t i onar y di st ri but i on of forei gn debt. This i nt er pr et at i on seems bor ne out by t he
cross-sectional results for devel opi ng count ri es pri or to t he onset of t hei r debt
crisis in 1982. For this sampl e, the cross-sectional savi ng-i nvest ment association
is much l ooser t han for t he OECD sample. 48
(3) The Ger t l er - Rogof f i nvest ment model discussed in Sect i on 3 shows why
i nvest ment may respond posi t i vel y to hi gher r et ai ned earnings, t hat is, to hi gher
cor por at e saving. Thus, it seems pl ausi bl e t hat in count ri es wi t h hi gher saving
rates, t he cost of capital will be l ower and i nvest ment higher. A mai n predi ct i on
of t he mor al - hazar d model is t hat risk-free i nt erest rates are equal i zed among
count ri es - as i ndeed t hey most l y are in t he i ndust ri al i zed worl d (Obst fel d 1995)
- whereas t he margi nal pr oduct of capital is high in count ri es wi t h low corpo-
rat e weal t h. Al t hough t her e is some evi dence in favor of this hypot hesi s, an
account of how cor por at e saving and i nvest ment are r el at ed need not have
st rong i mpl i cat i ons for t he rel at i onshi p bet ween t ot al saving and i nvest ment .
For exampl e, pri vat e domest i c owners of firms may pierce t he cor por at e veil
47The fragility of the econometric evidence is illustrated by Feldstein and Bacchetta's (1991)
reinterpretation of the regressions Summers (1988) offers as evidence of current-account targeting.
48See Fieleke (1982), Dooley, Frankel, and Mathieson (1987), and Summers (1988).
and offset corporate saving decisions through their own consumption. To the
extent that the investing firms are owned by foreigners, their decision to retain
earnings increases foreign rather than domestic saving, other things equal.
(4) In a Heckscher-Ohlin framework, a nonspecialized economy experiencing
a rise in saving can absorb more capital without a fall in capital's domestic rate
of return. Alternative explanations of the saving-investment association based
on this observation are suggested by Fukao and Hamada (1994) and Obstfeld
(1995).
(5) In the life-cycle theory of consumption, sustained demographic or pro-
ductivity changes that increase a country's long-term investment rate also may
increase its saving rate. Section 3.1.7's discussion of overlapping-generations
models provides a leading example: higher productivity growth that affects most
strongly the incomes of young workers will cause saving as well as investment
to rise. Feldstein and Bacchetta (1991) and Summers (1988) have dismissed
this line of explanation, notwithstanding some supportive evidence offered by
Tesar (1991). In a more recent contribution, however, Taylor (1994) revisits the
Feldstein-Horioka equation, controlling for (a) measures of domestic relative
prices, (b) the age-structure of the population, and (c) the interaction of the age
structure with the growth rate of domestic output. He finds that for a number
of country samples the cross-sectional saving-investment association disappears.
Far from showing the irrelevance of the intertemporal approach, the large
literature spawned by Feldstein and Horioka' s (1980) nonstructural exploration
suggests to us that models like those reviewed in Section 3 capture key elements
behind the cross-sectional and time-series regularities governing saving and in-
vestment rates. The further empirical challenge for the intertemporal approach
is to show that structural forward-looking models of the current account are
not grossly incompatible with actual experience. We turn next to tests of such
models.
4 . 2 . Tes t s " o f i n t e r t e m p o r a l c u r r e n t - a c c o u n t m o d e l s
Most structural time-series studies of the intertemporal approach to the current
account essentially test versions of eq. (3.9), according to which the current
account depends on deviations of interest rates, output, government spending,
and investment from "permanent" levels. Indeed, most (but not, as we shall
see, all) of these studies focus on the special case of (3.9) with a constant real
interest rate r = (1 -/3)//3
C A t = ( Y t - Y t ) - ( G t - G t ) - ( I t - I t ) (4.46)
Though less general than eq. (3.9), eq. (4.46) embodies many central ele-
ments of the intertemporal approach. It therefore is reasonable to ask whether
t her e is any evi dence in f avor of (4.46) bef or e t urni ng t o mor e compl ex model s.
For exampl e, do t e mpor a r y rises in gover nment spendi ng cause cur r ent - account
deficits? Quest i ons like this one seem si mpl e enough, but a numbe r of empi ri cal
subt l et i es arise in answeri ng t hem.
4. 2. l . M e a s u r i n g p e r m a n e n t v al ue s ' : A d i g r e s s i o n
Eve n bef or e t ur ni ng t o t he economet r i c studies, it is useful to address what
is per haps t he most pr obl emat i c issue of all, t he const r uct i on of t he expect ed
pe r ma ne nt val ues Y, G, and I.
A first difficulty is t hat it is not obvi ous what real i nt er est r at e to use to
di scount expect ed f ut ur e out put flows. 49 Most of t he st udi es sur veyed bel ow
use fai rl y low di scount rat es, in t he r ange of 2 to 4 per cent per year. Thes e
number s cor r es pond r oughl y t o aver age ex post real r et ur ns on U.S. Tr easur y
bills post - Wor l d War II. But is a ( nomi nal l y) riskless r at e t he appr opr i at e onc
f or di scount i ng ver y ri sky f ut ur e out put flows? For t he Uni t ed States, t he mean
r at e of r et ur n on ri sky assets has hi st ori cal l y been much hi gher t han t hat on
bonds [Mehra and Pr escot t (1985)], at l east since t he l at e ni net eent h century.
To t he ext ent dat a are avai l abl e, a si mi l ar resul t seems t o hol d for a numbe r of
ot her count ri es. Be r na nke (1985) argues t hat an annual real i nt er est r at e as high
as 14 per cent is ne e de d t o r at i onal i ze U.S. c ons umpt i on- i nc ome rel at i onshi ps
in a r el at ed cl os ed- economy setting.
A second di ffi cul t y concer ns t he sensi t i vi t y of empi ri cal measur es of Y, G,
and i t o appar ent l y beni gn di f f er ences in t he t i me seri es process gener at i ng t he
under l yi ng val ues of Y, I, and G. Thi s pr obl em i nt er act s wi t h t he pr evi ous one,
because t he sensi t i vi t y t o t he dat a- gener at i ng process is especi al l y acut e under a
l ow i nt er est rat e. 5 Consi der t he fol l owi ng exampl e, in whi ch out put ( expr essed
as a devi at i on f r om me a n out put ) is gener at ed by t he pr ocess
Y t = P Y t - 1 + v t (4.47)
wi t h 0 < p _ 1, v t a whi t e- noi se error, and t i me meas ur ed in years. If a l ow real
i nt er est r at e is used t o const r uct pe r ma ne nt out put
r E Y+I + _ _ + . . (4.48) #, - -
- - - l + r 1+---7- ( l + r ?
di st ant f ut ur e i ncomes will have r el at i vel y l arge weights. Whe n r -- 0.03, Et Yt+20,
f or exampl e, t hough di scount ed, still has a wei ght mor e t han hal f t hat of cur r ent
out put , Y r . Thi s means t hat when r is low, est i mat es of Yt ma y be ver y sensi t i ve
t o t he ser i al - cor r el at i on pa r a me t e r p, especi al l y in t he nei ghbor hood of p = 1.
Not i ng t hat under eq. (4.47) Et Yt+k = p k Y t , one sees t hat eq. (4.48) implies:
49Sometimes this issue can be finessed [see t he discussion of Glick and Rogoff (1995) below.]
5This discussion draws on Glick and Rogoff (1995).
Yt -- r Yt - txYt (4.49)
l +r - p
When p = 1, /~ = 1 and so lTt = Yt, regardless of the value of r. But when
r = 0.03 and p --= 0.97 (a value differing from 1 by an amount generally t oo
small to detect empirically), /x drops to only 0.5: permanent out put is half of
current output. As p becomes small this hypersensitivity abates. In practice,
unfortunately, p tends to be quite close to 1, so that the presence of a unit
root is difficult to reject. It should be clear that estimates of Yt can be similarly
sensitive to estimates of time trends. 51
The present-value calculations are less sensitive to p when the real interest
rate is higher. How high must real interest rates be'? With r = 0.14 (the value
ment i oned by Bernanke) and P -- 0.97 in eq. (4.49), /~ = 0.824. With r - 0.5,
/x -- 0.943. Real interest rates high enough to make /x insensitive to p in the
vicinity of a unit root appear implausible.
With these cautions in mind we proceed to look at the literature.
4.2.2. Earl y tests'
Earl y economet ri c tests of the intertemporal approach as represent ed by eq.
(4.46) include Ahmed (1986, 1987), Hercowitz (1986), and Johnson (1986).
Hercowitz, who looks at Israeli data over 1950-1981, presents some support
for an i nt ert emporal model but also finds that the model exaggerates the cur-
rent account' s response to output fluctuations. Johnson focuses on Canada over
1952-1976. He rejects Ricardian equivalence, but concludes that Canada' s pri-
vate sector can plausibly be model ed in line with a version of the i nt ert emporal
approach that allows for some liquidity-constrained consumers. 52
Ahmed' s papers are distinctive in their use of long historical data series on
government expenditures from the Uni t ed Kingdom. In the 1986 paper, Ahmed
looks at annual 1908-80 data to gauge the impact of U.K. government spending
on the current account (actually, the trade balance, TB). The 1987 paper ana-
lyzes a pre-Worl d War I sample on public military spending and trade balances
running from 1732 to 1913. Ahmed argues that the expenditures accompany-
ing Britain' s wars were largely exogenous and were almost certainly viewed as
t emporary by the public. Thus, on the basis of the i nt ert emporal approach, one
51The same problems arise in the macroeconomic literature on estimating consumption functions.
Deaton (1987), for example, argues that if income is stationary in growth rates (a hypothesis that
is difficult statistically to reject given the limited post-WWII time series), then consumption should
move more than one-for-one with income innovations. There is, on the other hand, no "Deaton's
paradox" if income is highly serially correlated but still stationary.
52Roubini (1988) combines the intertemporal approach with the tax-smoothing theory of govern-
ment deficits, finding mixed results for a sample of OECD countries.
Ch. 34: The IntertemporaI Approach to the Current Account
1854 Pounds (Mi l l i ons)
20
1783
Military Spending
15
10
A C u r r e n t A c c o u n t
0
1701 1722 1743 1764 t 7 8 5 1806 1827 1848 t 8 6 9 1890 1911 1932
Figure 4.2. United Kingdom: Military spending and current account, 1701-1938 (detrended annual
data).
might expect Britain to have been running external deficits during wars. 53 In the
twentieth century, swings in British government spending have been dominated
by the two world wars, both of which were accompanied by large current-
account deficits. Figure 4.2 uses data from Ahmed' s papers to graph military
spending against the current account over 1701-1938. 54 This 238-year sample
provides a more demanding testing ground than the twentieth century alone, as
the period is punctuated by many wars. 55
A negative correlation between surges in government spending and the cur-
S3The result that temporary war-time increases in public spending should lead to an external
deficit does not necessarily hold if the whole world is at war. In an all-encompassing global war,
higher government spending everywhere would push up world interest rates with current account
implications that would depend mostly on countries' net external asset holdings. This point illustrates
the distinction between global and country-specitic shocks emphasized in Section 3 above.
54Both series have had a 2 percent annual growth trend removed, as in Ahmed (1987). The current
account has been constructed from Ahmed' s trade balance data using a 3 percent per annum sterling
rate of return on foreign assets starting from an assumed zero net foreign asset position in 1701.
We thank Shaghil Ahmed for providing us with the data from his papers.
55The possible gain or loss of colonial territories and privileges, which was the motive for much
warfare before World War I, naturally could be expected to exert an additional wealth effect on
the current account Ideally, this effect should be controlled for in estimation.
r ent account is ful l y consi st ent wi t h t heor i es ot her t han t he i nt e r t e mpor a l ap-
pr oach, f or exampl e, a Keynes i an mul t i pl i er model . To r educe t he set of al t er-
nat i ve t heor i es consi st ent wi t h t he dat a, Ah me d expl or es f or mal e c onome t r i c
tests. A r epr es ent at i ve resul t f r om Ah me d (1986) is
TBt = - 0. 21 (Gr - Gt ) - 0.44 Gt + et; R 2 = 0.28, D. W. = 2.32
(0.05) (0.88)
whi ch is e s t i ma t e d over 1908-80. 56 Thi s r egr essi on shows t hat t he t e mp o r a r y
c o mp o n e n t of gove r nme nt spendi ng has a si gni fi cant negat i ve i nfl uence on t he
cur r ent account , wher eas t he pe r ma ne nt c ompone nt i t sel f does not , consi st ent
wi t h (4.46). Unf or t unat el y, t he r egr essi on' s speci fi cat i on l eaves ope n t he possi -
Nl i t y t hat Gt is t he onl y significant de t e r mi na nt of t he cur r ent account and t hat
Gt pl ays no r ol e at all - as an a t e mpor a l Keynes i an model woul d predi ct .
Us i ng our es t i mat ed cur r ent account in pl ace of t he t r ade bal ance, we have
r un a si mi l ar r e gr e s s i onon t he 1701-1938 dat a, but whi l e keepi ng Gt - Gt in t he
r egr essi on we r epl ace Gt by Gt so as t o e nc ompa s s t r ans par ent l y t he i nt er t em-
por al and Ke yne s i a n al t er nat i ves wi t hi n a single test. 87 The r esul t i ng r egr essi on,
r un usi ng a Co c h r a n e - Or c u t t cor r ect i on f or f i r st - or der seri al cor r el at i on is 58
CAt ---- - 0 . 0 1 6 ( Gt - Gt ) - 0.028 Gt + et; p = 0.907
(0.013) (0.093) (0.027)
I n this speci fi cat i on, nei t her cur r ent nor p e r ma n e n t gove r nme nt spendi ng is
i ndi vi dual l y significant. As usual , it is uncl ear whe t he r t he i nt e r t e mpor a l ap-
pr oa c h is s i mpl y fal se, or whe t he r t he ma n y e xt r a ne ous si mpl i fi cat i ons and mai n-
t ai ned hypot he s e s i mpos ed by t he economet r i ci an ar e to bl ame. I t is t he r e f or e
useful t o t ur n t o a newer empi r i cal a ppr oa c h bas ed on a less r est r i ct i ve f r a me -
wor k.
4.2.3. Pr es ent - val ue mode l s o f t he current account
Gh o s h (1995), Ot t o (1992), and Sheffri n and Woo (1990) appl y an al t er nat i ve
me t h o d o l o g y t hat ma ke s use of t he i nf or mat i on e mb o d i e d in past cur r ent ac-
count s t o ma k e mor e accur at e pr edi ct i ons of I 7", G, and [. Thes e st udi es bui l d on
t he me t h o d o l o g y devel oped by Ca mpbe l l (1987) and by Ca mpbe l l and Shi l l er
(1987). 59
56See Table 1, regression I (with p = 0.02) on p. 211.
57To form G we used an autoregressive forecasting model of detrended government spending.
58Similar results are obtained when we use the trade balance in place of the current account, as
Ahmed (1987) does.
59Campbell's (1987) study of private U.S. saving is especially relevant to the current-account
studies we are about to discuss. Comparison with Campbell's results is difficult, however, because
he examines a different question, the accumulation of private wealth of all kinds in response to
fluctuations in after-tax labor income.
Defi ne
Q~ Y - G- I
The st art i ng poi nt for t he present -val ue met hodol ogy is again eq. (4.46), ex-
pressed in the f or m
CAt = Qt - Qt (4.50)
The new vari abl e Q can be t hought of as the net pri vat e noni nt er est cash flow.
Al t hough the mai n i nnovat i on of the Campbel l - Shi l l er approach does not real l y
requi re it, Ghosh, Sheffri n-Woo, and Ot t o all fol l ow Campbel l and Shiller in
rewri t i ng eq. (4.50) as
CAt = --Et ~ ~ AQs (4.5:l)
s=t+l
where &Qt = Qt - Qt-1 is the di f f erence of t he cash flow variable. Equat i on
(4.51) says t hat t he current account bal ance t ends to be negat i ve when net
cash flow is expect ed t o rise, and positive when net cash flow is expect ed to
fall. Condi t i onal expect at i ons are assumed t o be l i near proj ect i ons on available
i nf or mat i on.
What advant age is t here to est i mat i ng eq. (4.51), wher e Qt ent ers in dif-
f er enced form, r at her t han eq. (4.50), where its level ent ers? The di fferenced
versi on is appr opr i at e if one is concerned t hat t here is a uni t root in Qt, so t hat
removal of a t i me t r end is not sufficient for stationarity. 6 If Qt is i ndeed I(1)
(has a uni t root ), t hen, as Campbel l and Shiller have emphasi zed, eq. (4.51)
allows one to use the st at i onar y vari abl e zXQt as a regressor wi t hout havi ng to
di fference bot h CA and Q, which is inefficient in the l i kel y event t hat CA is
stationary. 61
The f undament al di fference bet ween the Ghosh, Shef f r i n- Woo, and Ot t o ap-
pr oach and earl i er studies concerns how one proxi es for pri vat e agent s' expec-
t at i ons of fut ure val ues of Q. The basic insight of t he Campbel l - Shi l l er met hod-
ol ogy is t hat as l ong t he i nf or mat i on set used by the economet r i ci an does not
cont ai n all the i nf or mat i on available to pri vat e agents, t hen past val ues of CA
cont ai n i nf or mat i on useful in const ruct i ng est i mat es of agent s' expect at i ons of
f ut ur e val ues of Q. Obviously, i ncorporat i ng this insight doesn' t act ual l y requi re
using first di fferences, as in eq. ( 4 . 5 1 ) , r at her t han levels, as in eq. (4.50).
Suppose, for exampl e, t hat one forms expect at i ons of f ut ur e val ues of d~Qt
by first est i mat i ng a first-order VAR (the general i zat i on to hi gher-order VARs
is st rai ght forward)
6Ghosh (1995) cannot reject the hypothesis of a unit root in Ot for his sample. Sheffrin and Woo
(1990) and Ot t o (1992) report similar results.
61Trehan and Walsh (199l) discuss conditions under which stationarity of CA is necessary for a
country' s intertemporal budget balance.
[ C A t - i ] LeztJ
and t hen makes use of i t s i mp l i c a t i o n t hat
E t k C A , + k ] = 4,3 4 , 4 ] LCA,] ( 4 . 5 3 )
to form an est i mat ed current account, CAt . 62 If i is the 2 x 2 identity matrix
and ~ the matrix of the 4,s, then eqs. (4.51) and (4.53) imply that
C- A t : - [ 1 0 ] [ ( l +r ) - - l ~] [ I _ ( 1 + r ) _ 1 ~ ] - 1LCAt ][A Q t
[ A e , l
-~ [CbaQ q)CA] [ CAt ] (4.54)
If the version of the intertemporal approach embodi ed in (4.51) is true, then
the theoretically predicted value of [eaQ @cA] in (4. 54)is simply [0 1]! The
reason this restriction emerges is obvious when the VAR captures all informa-
tion peopl e use to forecast future cash flow. The same restriction also holds
true, however, when the VAR captures only a subset of that information. The
reason is that - CA t captures the representative consumer' s best estimate of the
present value of future cash-flow changes, regardless of what ot her information
he or she has.
Ap p l y i n g the above approach, Sheffrin and Woo find that the restriction
CAt = CAt is rejected for Canada, Denmark, and the U.K. in their 1955-
85 sample, although it is not rejected for Belgium. Ghosh, whose sample peri od
is 1960-88, finds that the restriction is not rejected for the U.S., but that it fails
for Canada, Germany, Japan, and the Uni t ed Kingdom.
Equat i on (4.54) leads to a stringent test of the model, but a number of more
general tests less sensitive to maintained hypothesis could be applied. One basic
implication of the model is that CAt should Granger-cause AQt. Ghosh finds
that in his full sample, even this weaker test still is passed only by the Uni t ed
States data. Sheffrin and Woo arrive at more positive results. Anot her approach
is adopt ed by Ot t o (1992), who tests the restriction that
Et-1 { CA, - AQ, - ( 1+ r ) CAt _t } = 0
which follows straightforwardly from eq. (4.51). Ot t o rejects the present-value
model for Canada and the U.S. after finding that lagged variables help in pre-
dicting CAt - AQt (1 + r) CAt _l .
62Once agai n, t hi s r e qui r e s a choi ce of t he c ons t a nt r eal r i s k- f r ee i nt er es t r at e r.
Ch. 34: The Intertemporal Approach to the Current Account /787
Whi l e the f or mal evi dence t her ef or e is very mi xed, 63 Ghosh, Sheffrin and
Woo, and Ot t o all stress t hat the i nformal evi dence obt ai ned by simply lining
up act ual current account s wi t h t he model ' s predi ct i ons can be quite impressive.
Thi s perspect i ve is useful, because no empi ri cal model is l i kel y to be literally
true. In Fi gure 4.3, we graph two illustrative cases, Sweden and the Uni t ed
Ki ngdom, using post war data; bot h figures are based on a first-order VAR with
AQ and CA as discussed above. The model performs ver y well for Sweden, but
poor l y for the Uni t ed Ki ngdom. One pr obl em mi ght be t hat t he model does
not explicitly i ncor por at e the effects of oil prices changes, which have been
i mpor t ant for Bri t ai n in recent years.
I ndeed, if one ext ends the dat a on Gr eat Bri t ai n over a l onger historical
peri od, t he model ' s per f or mance looks much better. For annual British dat a
over t he per i od 1870-1991, a first-order VAR for dxQ and CA yields 64
AQt] = [ 0. 24 -0.14] [AQt-11
CAt] - 0. 11 0.84 ] [CA,_I]
Fi gure 4.4 is const r uct ed using t he above est i mat es and assumi ng a real in-
t erest rat e of 4 per cent per annum. Ext endi ng t he dat a set yields a dramat i cal l y
bet t er fit t han when one est i mat es t he model over post -Worl d War II dat a alone.
Though t he visual evi dence is fai rl y striking, t he model still fails a formal test
of t he rest ri ct i on embodi ed in eq. (4.54). Fr om t he above VAR est i mat es, one
o b t a i n s [~)zxO ~CA] = [--0.26 0.54], which differs significantly from t he null
hypot hesi s val ue of [0 1 I.
A common t heme in the graphical evi dence pr esent ed by Ghosh, Shef f r i n-
Woo, and Ot t o is t hat t he actual current account is of t en far mor e vol at i l e t han
t he pr edi ct ed current account. This seems to cont radi ct t he Fel ds t ei n- Hor i oka
concl usi on t hat current account movement s are rel at i vel y small compar ed to
what one woul d expect in theory. Ghosh f or mal l y compares t he vari ances of the
pr edi ct ed and act ual current account series and finds t hat , except in the U.S.
case (where he cannot rej ect equal i t y of the variances), t he vari ance of t he actual
series is higher. Ot t o si mi l arl y finds t hat Canada' s current account is six t i mes as
vol at i l e as t he pr edi ct ed series. 65 Ghosh i nt erpret s his finding as evi dence of "t oo
63Ghosh and Ost ry (1995) apply the present -val ue approach to devel opi ng countries and argue
t hat , if anything, it performs bet t er t han for industrialized countries. They find t hat across a large
sampl e of developing countries, t he level and volatility of net capital movement s predi ct ed by
t hei r consumpt i on-smoot hi ng model closely parallels those in t he data. This finding is puzzling -
devel opi ng count ri es' capital mar ket s t end to be less open t han those of t he industrialized countries
- but one possible expl anat i on relies on t he distinction bet ween global and country-specific shocks
t hat we make below. Plausibly, developing countries are relatively mor e susceptible to country-
specific as opposed t o global shocks, so t hat t he present -val ue model, which assumes a given and
const ant real i nt erest rate, does somewhat better.
64Historical dat a are from Fei nst ei n (1972) and Maddi son (1991).
6SSheffrin and Woo' s dat a (which t hey generously supplied to us) yield similar results.
1788
M. Obstfeld and K. Rogoff
1985 Kronor per Capita
4000
3000
2000
1000
0
-1000
-2000
-3000
Actual
'kt
Predicted I'l
1952 1956 1960 1964 1968 1972 1976 1980 1984 1988
1985 Pounds per Capita
200
100
-100
-200
-300
V V Predicted
J
19501954195819621966197019741978 19821986 1990
Figure 4.3. Sweden: Actual and predicted current account balance (annual data).
Ch. 34: 7"he Intertempora! Approach to the Current Account 1789
1914 Pounds per Capi t a
6
2
0 . . . . . . . . . . . . . . .
-2
-4
-6.8 Predicted A
-10
-12
1871 1882 1893 1904 1915 1926 1937 1948 1959 1970 1981 1991
Figure 4.4. United Kingdom: Actual and predicted current account balance (annual data).
much" capi t al mobi l i t y, in cont r ast t o t he Fe l ds t e i n- Hor i oka cl ai m of t oo little.
One possi bl e expl anat i on of t he Gh o s h - Ot t o findings is t o vi ew t hem as r el at ed
t o Deat on' s par adox of excessi ve consumpt i on smoot hness. The De a t on par adox
can be r esol ved by st i pul at i ng t hat i ncome, t hough hi ghl y seri al l y cor r el at ed,
does not l i t eral l y cont ai n a uni t root . ( When i ncome is st at i onar y in growt h
rat es r at her t han in levels, a small change in cur r ent i ncome can i mpl y a ver y
l arge change in pe r ma ne nt i ncome and, hence, in pr edi ct ed consumpt i on. ) Just
as t he assumpt i on of a unit r oot in i ncome can l ead t o t he concl usi on t hat
cons umpt i on is t oo smoot h, it can also pr oduce t he resul t t hat saving or t he
cur r ent account is t oo vol at i l e. Thi s may hel p expl ai n t he Gh o s h - Ot t o vol at i l i t y
results, t hough f ur t her i nvest i gat i on is r equi r ed.
4.2.4. Gl obal versus country-specific shocks' and the current account
One shor t comi ng of t he studies consi der ed so far is t hei r i mpl i ci t assumpt i on
t hat all shocks t o cash flow ar e pur el y i di osyncrat i c. 66 In reality, even a smalI
count r y' s out put gr owt h or i nvest ment may be hi ghl y cor r el at ed wi t h t hat in t he
rest of t he worl d. Out put shocks whi ch i dent i cal l y i mpact all count r i es should,
however , expr ess t hemsel ves pr i mar i l y t hr ough t he gl obal i nt er est rat e, and not
66This criticism, of course, applies with equal force to much of the macroeconometric literature
on consumption.
in i ndi vi dual count ri es' current accounts. Gl i ck and Rogof f (1995) argue t hat this
issue is empi ri cal l y i mpor t ant and try to conf r ont it. Thei r model also at t empt s
t o trace shocks t o out put and i nvest ment back to changes in fact or productivity,
al l owi ng for mor e st ruct ure t han the empi ri cal studies j ust discussed. 67 A si mpl er
versi on of t he Gl i ck- Rogof f f r amewor k suffices t o i l l ust rat e t hei r mai n points.
Let ' s label t he country-specific component of cash flow Q~: and the gl obal
component QW, so t hat
A Q = A Q c + A Q w
The gl obal component is the part of Q t hat is perfect l y correl at ed with average
worl d Q. Then, assumi ng t hat QC is 1(1), and t hat initial net forei gn asset po-
sitions are zero, one can ( a f t e r m a n y s t e p s ) show t hat eq. (4.51) is repl aced by
t he appr oxi mat e current -account equat i on 68
C A t = - E t -1-+-~r A Q,~ (4.55)
s=t+l
wher e t he i nt erest rat e used is t hat prevai l i ng al ong an initial st eady-st at e pat h.
Accor di ng t o (4.55), onl y country-specific shocks affect current accounts. 69
To separ at e QC from QW, Glick and Rogof f consi der annual dat a for the G-7
count ri es over 1960-90, t reat i ng these count ri es as t he worl d (which, in t erms of
economi c size, isn' t a bad appr oxi mat i on for most of t hei r sampl e period). They
consi der t wo al t ernat i ve met hods of separat i ng shocks i nt o local and gl obal
component s. The simplest is to form QC as Q - QW, where QW is t aken to be
a mean- GNP wei ght ed average for t he ent i re group. The mor e sophi st i cat ed
approach is to regress each count ry' s AQ on an i ndex of the r emai ni ng coun-
t ri es' cash flows, defining QC as the regressi on residual. Glick and Rogof f find
t hat the t wo approaches yi el d similar results for t hei r ul t i mat e current -account
and i nvest ment equat i ons. Overall, gl obal shocks appear to account for a ver y
significant por t i on of t ot al product i vi t y shocks in t he G-7 count ri es, r oughl y
50 percent . 7 Gl i ck and Rogof f find t hat t he gl obal versus country-specific dis-
t i nct i on great l y i mproves t he ability of the i nt er t empor al approach to expl ai n
67Leiderman and Razin (1991) develop a model similar to Glick and Rogoff's, although they do
not distinguish between global and country-specific shocks.
68The derivation of equation (4.55) requires that the variances of the underlying productivity
shocks be constant. The global component of the shock, QW, affects world interest rates but not the
current account.
69If initial net foreign asset positions are not zero, the interest-rate effects of global shocks can
redistribute income from debtors to creditors in a way that alters current accounts. [Recall eq. (3.9)
above.[ Gliek and Rogoff show that this effect is empiricaUy small.
7Costello (1993) and Stockman (1988) have found, for slightly different country samples and
industry-level data, that global productivity or output shocks seem to be less correlated between
similar manufacturing industries in different countries than between different industries in the same
country. That evidence apparently points to a greater role for country-specific shocks, and it remains
to reconcile it with the results discussed in the text.
Ch. 34." The Int ert emporat Appr oach to the Current Account 1791
act ual current accounts: the coefficients on t he global shocks are i nvari abl y much
smal l er t han t hose on the country-specific shocks, and are usual l y insignificant.
4 . 2 . 5 . E x t e n s i o n s
The empi ri cal consumpt i on- smoot hi ng model s discussed so far all i gnore thc
pr ecaut i onar y mot i ve for saving, as was r emar ked earlier. Cabal l ero (1990) has
shown, however, t hat under specified assumpt i ons one can obt ai n cl osed-form
consumpt i on funct i ons based on t he peri od ut i l i t y funct i on u ( C ) - - e x p ( - u C),
wher e v is t he coefficient of absol ut e risk aversion. Thus, t here is no need
to rel y exclusively on a l i near-quadrat i c f or mul at i on for cl osed-form solutions.
Ghosh and Ost r y (1992, 1994) appl y Cabal l ero' s results to add a pr ecaut i onar y
saving effect t o the present -val ue model of the current account. 71 The key new
par amet er appeari ng in t hei r ext ended f r amewor k is o-g = Var(~'), where
~t = 0 t -- g r - I 0 t
is t he dat e-t i nnovat i on to expect ed per manent pri vat e cash flow. Ghosh and
Ost r y (1992) l ook at quar t er l y 1955-90 time-series dat a for Canada, Japan, the
Uni t ed Ki ngdom, and the Uni t ed States. Because t hey are l ooki ng at time-
series r at her t han cross-section dat a, t hey must negot i at e t he difficult issue of
t i me var i at i on in ~ , which is a condi t i onal vari ance in a dynami c setting. Long
enough i nt erval s must be al l owed for accurat e measur es of o-~, but intervals
shoul d not be so l ong as to precl ude enough dat a poi nt s for meani ngf ul time-
series regressions. 72 Usi ng two- to five-year intervals to measur e o- i , Ghosh
and Ost r y find t hat t hei r pr ecaut i onar y vari abl e usual l y ent ers significantly and
wi t h t he correct sign in present -val ue current account regressions. Ghosh and
Ost r y (1994) find similarly positive results for devel opi ng countries. Thei r poi nt
est i mat es suggest t hat pr ecaut i onar y savings are of t he or der of magni t ude of 5
per cent of i mport s for the Af r i can region, 4 percent for commodi t y export ers,
and 14 per cent for fuel exporters.
None of t he empi ri cal studies discussed thus far distinguishes bet ween dura-
bles and nondur abl es or bet ween t radeabl es and nont r adeabl es. As we empha-
sized in our t heor et i cal discussion, bot h distinctions can be i mpor t ant for the
current account. Bur da and Ger l ach (1993) argue t hat , in theory, durabl e-goods
i mport s are much mor e sensitive to expect ed movement s in the real exchange
rat e (because of t he resul t i ng expect at i ons of capital gain or loss) t han arc
nondur abl es i mport s. Est i mat i ng t hei r model poses a number of difficulties: in
particular, the t heor y calls for a measur e of t he stock of consumer durables,
but this is difficult to obt ai n in practice. Usi ng a vect or error-correct i on time-
71An alternative theoretical treatment is Rodriguez (1993).
72An alternative approach would be to adopt an explicit parameterization of Var~ ,(~:t).
series specification including quarterly data on the current account, expected
permanent net income, the relative price of durables in terms of nondurables,
and a variable capturing expected changes in that price, Burda and Gerlach
find that the expected price changes have a significant correlation with the U.S.
current account over 1970-88. This finding, they argue, provides support for
the empirical role of the durables versus nondurables distinction. It is difficult
to compare these results with those of the empirical models discussed earlier
because the Burda-Gerlach setup, with its very general lag structure, imposes
much less theoretical structure. It would be interesting to pursue an alternative
approach based on eq. (3.23). 73
Rogoff (1992) incorporates nontraded goods into an empirical intertemporal
model, although his primary focus is on explaining the well-documented near
random-walk behavior of real exchange rates. His main result is that intertem-
poral consumption smoothing in traded goods might account for the persistence
of innovations in real exchange rates. In the simplest case, assume exogenous
output of tradeables and nontradeables, a Cobb-Douglas period utility function
[p = 1 in eq. (3.17)], and an intertemporal substitution elasticity, or, of 1. In this
case, as we saw earlier, people smooth their consumption of tradeables inde-
pendently of the evolution of their nontradeables consumption. As above, the
real exchange rate, the relative price of nontradeables on date t, depends on
Grt, YNt, and consumers' expenditure shares. A permanent shock to tradeables
output raises Ca- permanently and thereby permanently raises the relative price
of nontradeables. But even a t emporary rise in traded-goods output raises Gr
permanently because of consumption smoothing. The model thus can explain
why the persistence in real exchange rate movements might be much greater
than that of the underlying exogenous shocks. A country's ability to borrow and
lend in international markets is the key to this result: it would not obtain absent
international capital mobility. Rogoff (1992) applies his model to data for Japan
and the United States, finding some support, though further testing is required.
5. How useful is the theory?
Even in its most rudimentary forms, the intertemporal approach to the cur-
rent account has proved valuable for analyzing a host of important problems.
Without an intertemporal approach, it would be hard to analyze or evaluate
the current-account patterns that followed the two oil shocks of the 1970s. The
dynamic budget constraints emphasized throughout this chapter are also essen-
tial in analyzing episodes of capital-market disruption, such as the developing-
country debt crisis of the 1980s. True, the standard intertemporal models must
73For some preliminary empirical results, see Obstfeld and Rogoff (1996), ch. 2.
Ch. 34: The I nt er t empor al Ap p r o a c h to t he Current Ac c o u n t ! 793
be ext ended t o t ake account of defaul t risk but, as we have seen, the mai n
qual i t at i ve insights do not change. More generally, model s t hat fail to i nt egrat e
i nvest ment , saving, and growt h make it vi rt ual l y i mpossi bl e to under st and why
some count ri es have persi st ent current account i mbal ances. Why, for exam-
ple, are Canada' s and Aust ral i a' s current accounts per enni al l y in deficit, and
Japan' s in surplus, despi t e wi de swings in t hei r currenci es' real exchange rates'?
Over l appi ng- gener at i ons vari ant s of the i nt er t empor al model are i ndi spensabl e
for t hi nki ng about how, say, the aging of Japan' s popul at i on coul d event ual l y
l ead to a fall in Japan' s persi st ent t rade surpluses.
As positive descri pt i ons of t he current account, t he simple i nt er t empor al
t heori es are not wi t hout t hei r limitations. As we saw above, simple time-series
model s based on consumpt i on smoot hi ng seem to work fai rl y well for some
count ri es (for exampl e, Sweden) but, in ot her cases, cl earl y miss much of the
action. Fur t her research allowing for t i me-varyi ng i nt erest rates, mul t i pl e goods,
durabl es, nomi nal price rigidities, and some l i qui di t y-const rai ned consumers
may l ead to bet t er descriptive power. If the si mpl est i nfi ni t el y-l i ved represent a-
tive agent model s are t o be believed, t hen it is a puzzle t hat ratios of forei gn
debt t o out put sel dom exceed 1:1 when plausible par amet er est i mat es suggest
t hat rat i os of 5:1 or 10:1 could easily be sust ai nabl e and even optimal.
Obser ved de bt - GDP ratios are easi er to rat i onal i ze in economi es with finite-
lived dynast i es, but such model s, while capabl e of embr aci ng a wi der set of
empi ri cal phenomena, also pose empirical puzzles. A fai rl y robust i mpl i cat i on
is t hat gover nment deficits l ead to current -account deficits, but the empirical
evi dence support i ng this predi ct i on, while suggestive, is har dl y a basis for st rong
conclusions. The striking i ndust ri al -count ry correl at i on observed over 1976-1985
is not cl earl y evi dent l at er on. Promi si ng directions for f ut ur e i nvest i gat i on in-
cl ude model s wi t h mor e det ai l ed i nt er gener at i onal st ruct ures and a mor e com-
prehensi ve account i ng of the i nt er gener at i onal t ransfers i mpl i ed by fiscal and
social i nsurance policies.
The model s we have discussed in this chapt er provi de onl y a st art i ng point.
Obviously, the t ask of bui l di ng and empi ri cal l y appl yi ng ri cher and mor e realistic
i nt er t empor al model s will not be an easy one. But t here is no avoi di ng this
chal l enge, since t he t wo l eadi ng al t ernat i ves to the i nt er t empor al model are
seri ousl y flawed.
One al t ernat i ve t hat has been expl ored ext ensi vel y in recent research is the
compl et e mar ket s model , in which country-specific shocks of all types - to hu-
man as well as financial weal t h, to personal as well as cor por at e taxes - can be
i nsured i nt ernat i onal l y. If this approach is correct, of course, t hen t he current
account is little mor e t han an account i ng convent i on wi t hout maj or significance
even for a count ry' s rel at i ve weal t h position. (See t he discussion in Section
3.2.1.) We have argued t hat real -worl d i nt er nat i onal capital mar ket s are very
far f r om the frictionless, ful l -i nformat i on, compl et e- mar ket s ideal. Fact ors ino
hibiting complete domestic capital markets include moral hazard problems in
lending at the microeconomic level, finite lifetimes, and difficulties in insur-
ing labor income. In international markets, these problems are compounded
by sovereign default risk, difficulties in insuring national government spending
shocks, and cultural and institutional differences. Of course, it would be vastly
preferable to model explicitly these capital-market imperfections rather than
simply to assume limited asset trade, especially for understanding the impact
of government policy. We have discussed some work along these lines and pre-
sented a simple example. Until these models have been more fully developed,
however, the intertemporal model seems to provide a much closer description
of reality than does the complete markets model.
Complete-market models represent an extreme alternative to the intertem-
poral approach. At the opposite pole are variants of the open-economy IS-LM
model due to Mundell (1968) and Fleming (1962). This approach, which ignores
intertemporal choice and even intertemporal budget constraints, remains over-
whelmingly dominant in policy circles. But as a framework for addressing funda-
mentally dynamic phenomena such as the current account and government debt,
the Mundell-Fleming paradigm, even when jerry-rigged with dynamic add-ons,
is fatally handicapped.
The Mundell-Fleming approach offers no valid benchmark for evaluating ex-
ternal balance. In practice, policymakers often strive to avoid a negative current
account. Just as efficient international trade generally requires unbalanced trade
across commodity groups, however, efficient trade across time often calls for
an unbalanced current account. The intertemporal approach identifies circum-
stances, for example, a transitory fall in output or a rise in domestic investment
productivity, that justify a current account deficit. On these issues, the Mundell-
Fleming approach has nothing to say.
Evaluating the real exchange rate consistent with full employment and exter-
nal balance is another prime concern of policy: intervention or realignment dc-
cisions may hinge on the determination that a currency's value is "misaligned".
Since the Mundell-Fleming approach has nothing to say about external balance,
it is, afortiori, unable to address the possibility of misalignment.
Because it lacks microfoundations or even the most basic intertemporal bud-
get constraints, the Mundell-Fleming approach provides no grounds for nor-
mative judgments on current accounts or international macroeconomic policies.
No economist would take seriously an assessment of tax, trade, or regulatory
policy based on a model with these shortcomings. The intertemporal approach
to the current account offers a viable framework for assessing macroeconomic
policy, one that must supplant the Mundell-Fleming framework for normative
questions.
It is hard to portray Mundell-Fleming as a successful positive current-account
theory, either. Without denying the theory's empirical appeal in capturing short-
Ch. 34." The lntertemporal Approach to the Current Account 1795
run ma c r o e c o n o mi c d e v e l o p me n t s ove r s o me e pi s o de s , t he c or e mo d e l has no
cl ear, mu c h l es s t e s t abl e , pr e di c t i ons a bo ut c ur r e nt - a c c o unt dynami c s . Ag a i n , as
i nt e r t e mpo r a l mo d e l s b e c o me mo r e t ract abl e and e n j o y wi de r empi ri cal t es t i ng,
it s e e ms t o us t hat t h e y mus t ul t i ma t e l y c o me t o s uppl a nt mo di f i e d Mu n d e l l -
Fl e mi n g mo d e l s f or po s i t i v e as we l l as n o r ma t i v e que s t i o ns .
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