Current Account Dynamics: A SVAR Analysis When the

Structural Shocks are not Orthogonal

César R. Sobrino- Universidad del TuraboEmail: sobrinoc1@suagm.edu

Ellis Heath- Valdosta State UniversityEmail: ebheath@valdosta.edu

Motivation

• Using Canada and UK, Kano (2008) analyzes the Intertemporal Current Account Approach (ICA).

• For a small open economy:• Current account is independent of global

shocks.• Current account responds positively to a

positive country-specific temporary shock.• Current account does not respond to

country-specific permanent shocks.

Motivation

• Three-variable SVAR with long run restrictions. Blanchard & Quah (1989).

• Ex-ante global real interest rate, net output growth and current account/net output.

• Permanent shocks to those series are the structural shocks.

• The variance-covariance matrix of structural shocks is the identity matrix.

Motivation

• Using a SVAR approach, his findings fit predictions

• But, there two puzzles:– Excessive response of the current

account to country-specific transitory shock.

– Country-specific transitory shocks dominate current account variations in the short and long run, but they do no play any role in net output growth fluctuations.

Motivation

• No correlation assumptions might be determining the Kano’s puzzles.

• Enders and Hurns (2007).– SVAR with long-run restrictions and

structural shocks are correlated at leads.– Idiosyncratic shocks should be

correlated due to fiscal and monetary policies.

Methodology

• Structural VAR

Methodology

• Variables– rt: ex ante global interest rate.

– ∆lnNOt: Net output growth

– CA/NOt: either current account over net output growth

VAR in reduced form

• Matrix of observed residuals

In this setup

• 9 unknowns: – three elements of B(0)– The variances of the structural shocks– The covariances of structural shocks

• 7 equations– 6 elements of variance-covariance

matrix of observed residuals.– A long run restriction:

In this setup

• Just identified system ,assuming no correlation between the global shock and idiosyncratic shocks.

• Then, idiosyncratic shocks are correlated at leads.

• Two schemes

Scheme I

• Country specific permanent shock () is previous to the country specific transitory shock ()

– Where delta is a pure demand-side shock

Scheme II

• Country-specific transitory shock )is previous to the country specific permanent shock ()

– Where phi is a pure supply-side shock

Data

• IMF, quarterly 1971:1-2006:2 for Canada and UK– The ex-ante global interest rate is a weighted

average of the ex-ante real interest rate minus the forecasted inflation in the G7 countries.

– The net output is the real GDP minus investment minus government expenses minus stock variation.

– The current account is the real GNP minus consumption minus investment minus government expenses minus stock variation

ADF Test

Variances and correlations coefficients

Scheme I - Forecast-error variance decomposition

Scheme II - Forecast-error variance decomposition

Scheme I – Canada: Impulse-response functions

Scheme I – UK: Impulse-response functions

Scheme II – Canada: Impulse-response functions

Scheme II – UK: Impulse-response functions