Habit Formation and the Present-Value Model of the Current Account: Yet Another Suspect (Revised as CARF-F-124 (2008) )

Takashi Kano

No CARF-F-101, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

Abstract: A recent paper claims that habit formation in consumption plays an important role in current account fluctuations in selected developed countries, extending the present-value model of the current account (PVM) with consumption habits. In this paper, however, I show that the habit-forming PVM is observationally equivalent to the PVM augmented with persistent transitory consumption, which is induced by world real interest rate shocks. Based on a small open-economy real business cycle (SOE-RBC) model endowed with consumption habits as well as world real interest rate shocks, this paper seeks effects of habit formation on current account fluctuations in a typical small open economy, Canada, by a Bayesian calibration approach. Results reveal no clear evidence that habit formation plays a crucial role in current account fluctuations.

Pages: 32 pages
Date: 2007-08
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