The Role of Non-Traded Goods in Current Account and Exchange Rate Determination: A DSGE Analysis

Christine Makanza

No 2016-04, School of Economics Macroeconomic Discussion Paper Series from School of Economics, University of Cape Town

Abstract: Most general equilibrium models of the current account focus on developed countries and assume that the evolution of the current account is caused by changes in the traded goods sector. However, emerging markets are typically characterised by a relatively large non-traded goods sector, which also affects macroeconomic fundamentals. This study contributes to the literature by calibrating a Dynamic Stochastic General Equilibrium (DSGE) model to analyse the impact of non-traded goods on the current account and exchange rate. The model is calibrated to South Africa, an economy with a large current account deficit and a large non-traded goods sector. The results show that non-traded goods play a significant role in the determination of the current account, with half the variation in the current account explained by non-traded goods productivity shocks. A large proportion of variation in the exchange rate is explained by risk premium shocks, but the contribution of these shocks decreases with the introduction of non traded goods in the model. The model provides a good fit to stylised facts, suggesting that the non-traded goods sector is vital for the evolution of the current account and exchange rate.

Date: 2016
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