Economics 15/05: A Dissection of the Current Account Persistence Puzzle

Abstract

The ratio of the current account balance to GDP is as persistent under floating rates as under pegged rates. We term this the “current account persistence puzzle”. This result contradicts economists’ widely held belief that current account imbalances should be corrected more quickly under floating. This belief consists of three elements: (a) imbalances will induce corrective real exchange rate movements; (b) real exchange rates move further under floating; and (c) larger real exchange rate movements will induce bigger shifts in the current account balance. It is shown that the data support (b) and (c) but not (a): the real effective exchange rate does not respond significantly to the current account balance.

Our results are based on the ratio of the current account balance to total trade, rather than GDP. This is because we expect a given movement in the real exchange rate to affect the former ratio to a similar degree across countries, which implies a bigger effect on the current account balance to GDP in more open economies where trade is larger relative to GDP. The results are robust to the choice of regime classification scheme, time variation of equilibrium values using a Hodrick-Prescott filter, and to recent regime switches. The implication is that the failure of real exchange rates to react as expected to current account imbalances is the main source of the puzzle.

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School Discussion Paper 2015-05, July 2015

Authors

Michael Bleaney and Mo Tian

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