Testing present value models of the current account: a cautionary note

Kenneth Kasa

No 2000-12, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: Following Campbell (1987) and Campbell and Shiller (1987), many papers have evaluated the intertemporal approach to the current account by testing restrictions on a Vector Autoregression (VAR). The attractiveness of the Campbell-Shiller methodology is that it is thought to be immune to omitted information. This paper uses results from Hansen and Sargent (1991a) and Quah (1990) to show that this is not true in certain (empirically plausible) situations. In particular, it is shown that if fundamentals are driven by unobserved (to the econometrician) permanent and transitory components, then the theoretical restrictions of a standard Present Value model of the current account might not be testable with a VAR. This is because the theoretical moving average representation can turn out to be noninvertible. This implies that observed data, including the current account, do not reveal the underlying shocks to agents' information sets. ; These results are potentially relevant given the results of several recent papers which claim that current accounts are 'excessively volatile'. I provide a simple example in which a researcher employing the Campbell-Shiller methodology is tricked into thinking the current account responds excessively to shocks when in fact the data are consistent with the theory.

Keywords: Balance of trade; International finance; Econometric models (search for similar items in EconPapers)
Date: 2000
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Published in Journal of International Money & Finance (August 2003, v. 22 no. 4)

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