The Role of Stock Markets in Current Account Dynamics: a Time Series Approach

This paper develops a simple model to study the impact of stock markets on the current account. The model allows for an arbitrary number of risky assets, which form an incomplete market, as well as a risk-free bond. A closed-form solution for the current account is derived from the optimal portfolio and consumption/saving choices of a representative agent. Formally, the model can be seen as a stock-market-augmented version of the “fundamental equation of the current account” popularized by Sachs. In order to make the main points of the model clear, I first solve it taking prices as given. A general equilibrium is analyzed in a companion paper.I suggest that the model sheds light on the recent US current account deficit. Some claim that this current account deficit reflects over-optimistic -“irrationally exuberant”- expectations of future stock market performance. The model, however, suggests that it is optimal for a country to run a current account deficit even if people do not expect the stock market boom to last. Another insight afforded by the model is that the current account may help predict future stock market performance and/or future endowments streams. This forecasting property can be formally expressed by a set of Granger causality and Granger causal priority propositions.