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The authors would like to thank Peter Isard, Guy Meredith, and Eswar Prasad for helpful comments. None of the views contained herein necessarily represent those of the IMF.
For instance, Prasad and Kumar (1997) allow for a larger set of shocks and find that demand shocks have little independent effect on the exchange rate, except for the United States, Canada, and Italy. In Bergin (2001), the core structural restrictions are rejected for one out of the three countries examined. Both of these approaches, however, offer a richer set of results pertaining to multiple variables.
An alternative long-term identification assumption, exploiting the fact that monetary shocks have no long-term effect on the current account, has been advocated by some, starting with Lane (2001). For our exercise, however, this identification assumption provides no discriminatory power. In models where the stock of net foreign assets is constant in a steady state, it is trivially true that shocks of all sources have no long-term effect on the current account.
This interpretation of temporary shock is approximately correct, as discussed in the previous section.
Nor can this be easily explained by possible over-aggregation of multiple shocks to two–temporary and permanent ones. Blanchard and Quah (1989) and Faust and Leeper (1997) discuss how two-shock representation of multiple shocks may undermine economic interpretation of VAR results. In our results, one might suspect that permanent effects of monetary shocks are stronger than is viewed in the literature. Stronger permanent effect of monetary shocks, however, would tend to ameliorate the positive association between the current account and the exchange rate that is induced by permanent shocks.
Going beyond our simple model, one could consider other kinds of permanent shocks that might generate the desired correlation. One example would be a permanent preference shock in favor of home exports.
In their paper, the permanent shock reduces domestic prices, and thus cannot be the positive productivity shock to the foreign country.