australia current account
of the current account, which has gained popularity in recent years, views the current account as the
outcome of forward-looking dynamic saving and investment decisions, and thus has the advantage of yielding more reliable policy conclusions than estimates from
ad hoc econometric specifications.3
The intertemporal (or consumption-smoothing) approach to the current account is derived from the permanent income theory of consumption and saving. In
predicting what capital flows should be if agents consume in accordance with their permanent income, the approach assumes a high degree of capital mobility, an
absence of capital market imperfections, and that agents follow consumption-smoothing behaviour. According to the intertemporal model, countries may
undertake external borrowing (run a current account deficit) to smooth the path of aggregate consumption in the face of temporary adverse shocks (which could
be productivity shocks, changes in government consumption spending or fluctuations in investment), yet will permanently lower aggregate consumption (leaving the
current account unchanged) in the face of permanent adverse shocks. This implies that temporary shocks may result in larger fluctuations in net national saving and
the current account than permanent shocks, and that the current account acts as a buffer to smooth aggregate consumption in the presence of temporary
disturbances. The key prediction of the consumption-smoothing model is that a country's current account will be in deficit (surplus) whenever national cash flow
(defined as gross domestic product minus government consumption spending minus investment) is expected to rise (fall) over time.
The concept of sustainability we use in this paper concerns whether current account balances are 'excessive'.4 As noted by Milesi-Ferretti and Razin ( 1996), the
question of whether given current account balances are 'excessive' can only be answered in the context of a model that yields predictions about the optimal
(equilibrium) path of external imbalances. The intertemporal model of the current account provides a benchmark to enable a judgement as to what capital flows
should be, given the shocks affecting an economy. According to the intertemporal model, the optimal value of capital flows (equivalent to the current account
position) is that amount which allows agents to fully smooth their consumption in the presence of shocks to national cash flow. Actual current account imbalances
can then be compared to the predicted optimal path of the current account, to determine whether the former have been excessive or not. Moreover, the optimal
current account imbalances (derived from the consumption-smoothing model) are sustainable by definition, because along the optimal path for private
consumption, net wealth remains constant. Accordingly, if (for example) the difference between the actual path of current account deficits and the optimal path of
current account imbalances is nonstationary (growing over time), then the actual path of current account deficits is unsustainable.
The paper contains a number of innovations over previous empirical analyses of the consumption-smoothing model. It emphasizes the recent literature on the
sustainability of external [next page]