Current account dynamics under information rigidity and imperfect capital mobility

Highlights

• The current account in developed countries is highly persistent and volatile.

• Standard intertemporal current account model cannot explain current account and consumption.

• Rational expectation (RE) in the model is replaced by sticky information (SI).

• SI model with imperfect capital mobility explains both current account and consumption.

Abstract

The current account in developed countries is highly persistent and volatile in comparison to their output growth. The standard intertemporal current account model with rational expectations (RE) fails to explain the observed current account and consumption dynamics. The RE model extended with imperfect capital mobility by Shibata and Shintani (1998) can account for the consumption dynamics, but only at the cost of the explanatory power for the volatility of the current account. This paper replaces RE in the intertemporal current account model with sticky information (SI) in which consumers are inattentive to shocks to their income. The SI model can better explain a persistent and volatile current account than the RE model but it overpredicts the persistence of changes in consumption. The SI model extended with imperfect capital mobility explains both the current account and consumption, provided that sufficiently high degrees of information rigidity and imperfect capital mobility are considered.

Introduction

During the first decade of this century, we observed that the United States and some countries in the euro area ran large current account deficits while China, Germany and the oil-producing countries ran large current account surpluses, resulting in the so-called global imbalances phenomenon. Since the presence of huge US current account deficits may lead in the future to costly rearrangements of the world economy, many researchers have intensively examined the sustainability of the US current account deficits, both from economic and policy perspectives. See, for example, Mann, 2002, Summers, 2004, Edwards, 2005, Roubini and Setser, 2005, Eichengreen, 2006, Rogoff, 2006, Obstfeld and Rogoff, 2007, Feldstein, 2008.¹ Recent studies further investigate the current account sustainability issue from wider perspectives. Aizenman and Sun (2010) examine the relationship between the duration of a country’s current account deficit and its relative GDP size and find that, except for the US, they are negatively correlated. Gnimassoun and Mignon (2016) clarify the interactions among current account imbalances, output gaps, and exchange rate misalignments. Cavallo et al. (2018) focus on the episodes of large and persistent deficits and show that financing investment by foreign funding is risky and likely to end up with drops in investment and growth.

Despite a large number of studies on the current account sustainability issue, the standard intertemporal current account (ICA) model has not been very successful in accounting for its characteristics.² The observed data on the net output growth suggest that the ICA model with rational expectations (RE) underpredicts the persistence and volatility of the current account in OECD countries.³ One of the reasons is that the predictions of the current account depend on consumption dynamics under the permanent income hypothesis. Under this hypothesis, changes in consumption have no serial correlation, but the observed changes in consumption are often persistent.⁴ Such persistent changes in consumption have often been explained by hand-to-mouth consumers who have no access to financial markets (e.g., Campbell and Mankiw, 1989, Campbell and Mankiw, 1990).⁵ In the context of the ICA model, the presence of hand-to-mouth consumers also means that the international capital mobility is imperfect. Shibata and Shintani (1998) study the ICA model with such imperfect international capital mobility. They estimate the degree of imperfect capital mobility that can be translated into the fraction of hand-to-mouth consumers in the economy. This hybrid RE model, which combines forward-looking consumers and hand-to-mouth consumers, can well explain consumption dynamics but undermines the predicted volatility of the current account.

The objective of this paper is to modify the ICA model by generalizing the model with sticky information (SI). To better explain current account dynamics, we replace RE in the ICA model with SI as developed by Mankiw and Reis, 2002, Mankiw and Reis, 2007, Reis, 2006. In the literature on the permanent income hypothesis, a number of previous studies have argued for the role of inattentiveness to shocks (e.g., Pischke, 1995, Sims, 2003, Reis, 2006, Luo, 2008, Sims, 2010, Luo et al., 2015, Gabaix, 2016, Carroll et al., 2018 among others). In these previous studies, agents are subject to information rigidities and inattentive to income shocks. The resulting consumption does not follow a random walk and the changes in consumption are persistent, depending on the degree of information rigidity. Overall, consumption dynamics with information rigidities are shown to fit the data of aggregate consumption well, unlike the RE model.

Following this line of research, we explore the current account dynamics under the SI model, one of the simplest models of information rigidity. Under SI, consumers cannot update their information with a constant probability. Consequently, some consumers are inattentive to news and such inattentive consumers stick to the consumption level planned in the past period. We demonstrate that the SI model can explain a persistent and volatile current account. The SI model is also good at predicting the volatility of changes in consumption. However, the SI model tends to overpredict the persistence of changes in consumption. To overcome this difficulty, we further investigate the hybrid SI model that combines forward-looking consumers with SI and hand-to-mouth consumers. Our finding is that, if we allow for a high degree of imperfect information and imperfect capital mobility, the hybrid SI model can account for both the current account and consumption. We obtained these findings using the Bayesian minimum distance estimator.

At least two important recent studies on open macroeconomy are closely related to our work in terms of the importance of information rigidity.⁶ The first is Luo et al. (2012) who extend the ICA model with rational inattention and robustness.⁷ While our paper is similar to theirs in that economic agents in our model imperfectly observe state variables, the primary focus of Luo et al. (2012) is on how robustness, that is, the uncertainty on the model economy, improves the ICA model’s prediction and its interaction with rational inattention.⁸ The other important contribution is Ekinci (2017) who develops the general equilibrium model under SI. His analysis of SI is motivated by explaining the well-known puzzles in the two-country, open-economy models, such as the real exchange rate volatility puzzle and the Backus-Smith puzzle. In contrast, our analysis of SI aims to understand the persistence and volatility of the current account in small open-economy models.⁹

This paper is organized as follows. In Section 2, we provide the evidence on current account dynamics. In Section 3, we present the RE and hybrid RE models and discuss the difficulty in reconciling the data. In Section 4, we describe the SI and hybrid SI models. Section 5 assesses their empirical performance. Section 6 concludes our analysis.