Interest Rates, Exchange Rates and Present Value Models of the Current Account

The relaxation of restrictions on international capital flows over the last several decades has greatly increased international integration in asset markets. One indication of this integration is the rise in capital flows used to finance current account deficits, and the resulting accumulation of substantial financial imbalances. Whether such imbalances are a matter of concern depends on the theoretical framework one uses to explain and interpret them. The intertemporal approach to the current account, in its simplest form, focuses on the optimal saving decision of a representative household as it smooths consumption. For example, considering a small open economy experiencing a temporary fall in output, the country would be expected to smooth consumption by borrowing in world capital markets and thereby run a current account deficit. This basic intertemporal model has been extended in many directions in the theoretical literature, to include investment, variable interest rates, nontraded goods, and even monetary policy.