Abstract
The paper analyses the effect of equity-price shocks on current account positions for the G-7 industrialized countries during 1974–2007. It uses a Bayesian vector autoregression with sign restrictions for the identification of equity-price shocks and to test empirically for their effect on current accounts. Such shocks are found to exert a sizable effect, with a 10 percent equity price increase, for example, in the United States relative to the rest of the world, worsening the U.S. trade balance by 0.9 percentage points after 16 quarters. However, the response of the trade balance to equity-price shocks varies substantially across countries. The evidence suggests that the channels accounting for this heterogeneity function both through wealth effects on private consumption and to some extent through the real exchange rate of countries.
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Notes
In the discussed model a fall in government spending, financed, for example, by lump-sum taxes for simplicity, is associated by a rise in private consumption and inflation, but a fall in aggregate output. As a result, the reaction of policy interest rates depends obviously on the monetary-policy rule. As argued in Fratzscher and Straub (2008), a standard Taylor rule implies a fall in interest rates, as the rise in inflation is relatively small, but the response of output is more pronounced for a wide range of structural parameters.
Appendix Table A1 lists the countries included.
Hau and Rey (2006) and Andersen and others (2007), for instance, show that there tends to be a negative correlation between equity returns and exchange rate returns in the data for several industrialized countries.
Appendix Table A2 lists the variables and their definitions and sources.
Moreover, this positive effect of asset prices on the exchange rate is not necessarily inconsistent with the literature that finds a negative correlation between equity returns and exchange rate movements (Hau and Rey, 2006; Andersen and others, 2007) as those correlations are unconditional ones and may stem from other types of shocks.
We show here only the corresponding results for the United States, though the conclusions on the robustness checks are qualitatively similar for other countries.
Relative equity-market capitalization is measured as the difference in the log domestic-market capitalization and the log rest-of-the-world market capitalization, both measured in U.S. dollars. Using market exchange rates or PPP exchange rates does not change the findings in a meaningful way. More precisely, although the magnitude of the impulse responses may change depending on the specification, the direction and dynamics is very similar across specification.
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Additional information
*Marcel Fratzscher is a division chief and Roland Straub a senior economist with the European Central Bank. The authors would like to thank the participants at the conference on “Current Account Sustainability in Major Advanced Economies” at the University of Wisconsin, Madison, and in particular our discussant, Ken West, for comments and discussion.