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Princeton University and International Monetary Fund, respectively. We thank Don Mathieson, Enrique Mendoza, Peter Montiel, Carmen Reinhart, and Peter Wickham for helpful comments and Brooks Calvo and Ava Ayrton-Lilaoonwala for assistance with the data.
Faruqee (1991) suggests that the effectiveness of capital controls in breaking the linkage between domestic and international interest rates has been declining over time.
On the view that recent capital flows into Latin America may have reflected speculative forces rather than economic fundamentals, see for example Rodriguez (1992).
For a somewhat different application of the consumption-smoothing approach in a developing-country context, see for example Paxson (1993).
The current account deficit is identically equal to the change in a country’s net international indebtedness, and thus is identically equal to the sum of all capital inflows, including changes in official reserves.
The idea that the current account should Granger-cause subsequent movements in national cash flow is reminiscent of Campbell’s (1987) hypothesis that saving should Granger - cause subsequent movements (declines) in labor income. This is the familiar “saving for a rainy day” hypothesis which states that, according to permanent income theory, people save when they expect their income to decline. The analogy for a small open economy is that national saving (net of investment) should help to predict subsequent declines in national cash flow.
The level of investment, i, is chosen so as to equate its marginal product with the exogenous world interest rate, r, independent of the path of consumption, i.e., Fisherian separability holds in this economy. It follows that the levels of investment and output may be treated as exogenous to the consumption decision under the assumption that r is exogenous.
It is simplest to work in terms of the social planner’s problem, although the competitive equilibrium yields equivalent results.
We follow Ghosh (1990), Sheffrin and Woo (1990) and Otto (1992) in assuming that Fisherian separability holds in this economy, so that investment and output may be treated as exogenous when choosing the optimal path of consumption in (3). Although, as shown in Mendoza (1992) for example, the Fisherian separation theorem holds strictly only in a world in which there are no stochastic shocks to the marginal productivity of capital, it continues to hold as a first approximation even in the presence of random investment shocks. Thus, the simple intuitions provided by the theorem, for example that consumption need not fall in order to finance an investment boom induced by a positive productivity shock, continue to hold even with random disturbances to the marginal product of capital.
Our model identifies the stationary component of the current account with consumption-smoothing behavior; more generally, it could include other transitory factors.
That is, in a regression of the change in national cash flow on the lagged current account and the lagged change in cash flow, the coefficient on the lagged current account should be statistically significant (Sargent (1979), page 278).
This is completely analogous to the notion, presented in Campbell (1987) in his study of the permanent income hypothesis, of “saving for a rainy day.”
If one took the theoretical model--with its infinitely-lived representative agent who has a constant subjective discount rate--literally, then Θ should be constant over the entire sample. Moreover, values of Θ which differed from unity--though not at all inconsistent with the theoretical model--would have the troubling implication that the most patient country would eventually own the entire world. We do not believe that such an extreme conclusion is necessarily warranted. Instead, we view the use of the infinite-horizon, constant discount rate model as a simple abstraction. The model provides a practical means of removing the trend in the current account which results from, inter alia, shifts in demographic and other factors not captured here, and allows one to focus on the consumption-smoothing aspect of the current account, which is our primary interest.
The countries for which the World Bank’s World Tables were used were as follows. Africa: Botswana, Nigeria, Senegal; Asia: India and Indonesia; Middle East: Egypt and Israel; and Western Hemisphere: Argentina, Brazil, Colombia, and Peru.
From (9), the coefficients Γy and Γca are nonlinear functions of the coefficients estimated in the VAR.
The standard errors need to be computed numerically as ΔΓ’ΣΔΓ where Σ is the variance-covariance matrix of the parameters of the VAR, and Δ(Γ) is the gradient of [Γy, Γca] with respect to the VAR parameters. The standard errors used in Tables 5-8 are White heteroscedastic-consistent standard errors calculated as:
where ϵi and ϵj are the residuals from the i th and j th equation of the VAR.
Unfortunately, these data are not available for most of the countries in the sample, although in future work we intend to use what data are available in order to shed some light on this question. Some preliminary work in this regard does indeed suggest that the model performs much better when one excludes the period of the debt crisis.
The X2 statistics follow a chi-squared distribution with degrees of freedom equal to the number of restrictions, in this case one.
It is also worth noting, as mentioned in the previous subsection, that for a number of countries, the point estimates of the variance ratio are below unity, which clearly is not consistent with a view that endogenous government behavior is driving our results.
As mentioned previously, the model does not work that well for some of the countries that were affected by the debt crisis. Indeed, from the charts, it may be noted that for a number of countries--including to some degree Argentina, Chile, the Philippines, Uruguay, and Venezuela--actual current account balances (surpluses) exceed optimal (predicted) current account balances for most of the period since 1982, as one would expect if capital inflows had been less than desired.