Macroeconomic Uncertainty, Precautionary Savings and the Current Account


WP/92/72-EA

Macroeconomic Uncertainty, Precautionary Savings, and the
Current Account by Atish R. Ghosh and Jonathan D. Ostry

The relationship between external current account developments and
changes in the macroeconomic environment remains a key issue in open-
economy macroeconomics. Modern theories of current account determination
have viewed the current account as a buffer to smooth consumption in the
face of shocks to output, investment, and government expenditure. For the
most part, models of the current account have assumed perfect foresight,
implying that there is no ex ante uncertainty regarding the future values
of various macroeconomic variables (income, government spending) that
affect consumption and saving decisions today. Indeed, the term shock
in these models merely refers to a onetime change in the exogenous
variables--events to which agents are assumed to have assigned a zero
probability.

This paper examines whether the insights afforded by existing inter-
temporal models of the current account remain valid once uncertainty is
explicitly incorporated. The intertemporal model of the current account
is extended to include the effects of precautionary savings and is tested
empirically. It is shown that the greater the uncertainty in national
cash flow--defined as output less investment less government expenditure--
the greater is the precautionary demand for savings and, other things being
equal, the larger will be the current account surplus. Empirical support
for the model is found using quarterly data from four large industrial
countries.