This paper examines the relationship between financial regulation and the current account in an intertemporal model of the current account where financial regulation affects the current account through liquidity constraints. Greater liquidity constraints decrease the size and persistence of the current account response to a net output shock. The theory is tested with an interacted panel VAR model where the coefficients are allowed to vary with the degree of financial regulation. The current account reaction to an output shock is 60% larger and substantially more persistent in a country with low financial regulation than in one with high financial regulation.
some long-term effects, as the level of net foreign assets changes in response. The typical finding, however, is that the long-run effect of monetary shocks on net foreign assets is small, and that the long-run exchange rate effect of monetary shocks is even smaller. A similar conclusion holds in our model, so that here the long-term exchange rate response is of lower order of magnitude than the already small currentaccountresponse.
To demonstrate this assertion, assume—consistent with Obstfeld and Rogoff (1996) —that prices of nontradables are fixed for one
deterioration in the trade balance.
Extensions of this basic analysis—again focusing on the saving side of the current account—have also supported the view that trade liberalizations have ambiguous effects on the external balance. Edwards (1988 , 1989) and Edwards and Ostry (1990 ) showed that the incorporation of nontradable goods could cause the comovement between liberalization policies and the current account to become ambiguous. 5 Murphy (1986) examined the issue of how the accompanying fiscal policies affect the currentaccountresponse to trade liberalization
Mr. Rabah Arezki, Valerie A Ramey, and Liugang Sheng
. They model consumption and investment goods sectors, and assume the same labor and capital shares. They show that the parameter space that is consistent with a positive effect of sector-specific news on aggregate hours is much smaller than for an aggregate shock; indeed, the lower panel of their Table 1 shows that the space is exceedingly small.
To summarize, our theoretical analysis shows that the currentaccountresponse to news is robust to sector-specific news shocks (whether labor share is high or low) and to aggregate TFP shocks. In every case, the current
deregulation in both OECD and emerging market countries ( figure 3 ) 4 , providing informal support for the ‘excess elasticity’ hypothesis. But, to our knowledge, no previous work has rigorously tested if and to which extent, the reaction of the current account depends on the domestic financial regulatory regime. In this paper, we take a step towards filling this gap. In particular, we provide the first empirical evidence that, for a given set of net output shocks, the currentaccountresponse is larger and more persistent in a country with a low, than in one with a high