Current Account Dynamics and the Real Exchange Rate: Disentangling the Evidence

We study the main shocks driving current account fluctuations for the G6 economies. Our

theoretical framework features a standard two-goods inter-temporal model, which is specifically

designed to uncover the role of permanent and temporary output shocks and the relation between the

real exchange rate and the current account. We build a SVAR model including the world real interest

rate, net output, the real exchange rate, and the current account and identify four structural shocks.

Our results suggest four main conclusions: i) there is substantial support for the two-good

intertemporal model with time-varying interest rate, since both external supply and preference shocks

account for an important proportion of current account fluctuations; ii) temporary domestic shocks

account for a large proportion of current account fluctuations, but the excess response of the current

account is less pronounced than in previous studies; iii) our results alleviate the previous puzzle in the

literature that a shock that explains little about net output changes can explain a large proportion of

current account changes; iv) the nature of the shock matters to shape the relationship between the

current account and the real exchange rate, which explains why is it difficult to find a simple

statistical relationship between these two variables.