Testing present value models of the current account: a cautionary note

Following Campbell and Shiller [J. Pol. Eco. 95 (1987) 1062], many papers have evaluated the intertemporal approach to the current account by testing restrictions on a Vector Autoregression (VAR). The attractiveness of the Campbell-Shiller methodology is that it is thought to be immune to omitted information. This paper shows that this is not always true. In particular, it is shown that if fundamentals are driven by unobserved (to the econometrician) permanent and transitory components, then the restrictions of a standard Present Value model of the current account might not be testable with a VAR. This is because the theoretical moving average representation can turn out to be non-invertible. This implies that observed data, including the current account, do not reveal the underlying shocks to agentsʹ information sets. The paper shows how researchers employing the Campbell-Shiller methodology can be tricked into thinking the current account responds excessively to shocks when in fact the data are consistent with the theory.