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A Model of Endogenous Nontradability and its Implications for the Current Account

Modern open-economy macroeconomics views the current account as a form of intertemporal trade, where countries borrow or lend to smooth their consumption levels across periods, while facing an intertemporal budget constraint and a real interest rate that reflects the price of borrowing. This intertemporal approach to the current account has long recognized that the existence of non traded goods limits the ability of countries to engage in such intertemporal trade. In a classic contribution to this literature, Dornbusch (1983) showed that when some goods are non tradable, the interest rate faced by a country in making its intertemporal decisions can deviate greatly from the interest rate prevailing in the world capital market.

For example, if a temporary rise in demand in a country generates a current account deficit, this rise in demand will tend to drive up the relative price of nontraded goods temporarily and hence the real exchange rate. The fluctuation in the real exchange rate effectively raises the real interest rate faced by this country, and dampens the optimal magnitude of the current account deficit. In this standard model, the cost of borrowing rises steadily and without bound as the country progressively tries to raise the level of current consumption by running ever larger current account deficits.

This theory offers a useful explanation for some empirical regularities. As demonstrated in the classic puzzle of Feldstein and Horioka (1980), the current account imbalances observed in reality for developed countries tend to be smaller than simple theories suggest would be optimal. In contrast, real exchange rates generally are found to be excessively volatile. It long has been observed that international relative prices are many times more volatile than corresponding quantity variables, like the trade balance and current account (see Backus, et. al., 1992).

The story above offers one simple way of understanding this relationship: a rise in demand in a country may lead endogenously to movements in the real exchange rate and real interest rate, and hence dampen current account imbalances. In this story, the larger is the fluctuation in the real exchange rate, the smaller is the movement in the current account.

A Model of Endogenous Nontradability and its Implications for the Current Account