CIRJE-F-572 "Habit Formation and the Present-Value Model of the Current Account: Yet Another Suspect"
Author Name Kano, Takashi
Date June 2008
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Remarks Revised Version of CIRJE-F-505(2007); revised version subsequently published in the Journal of International Economics, 2009, 78, p72-85.

A recent paper claims that habit formation in consumption plays an important role in current account fluctuations in selected developed countries, extending the present-value model of the current account (PVM) with consumption habits. In this paper, however, I show that the habit-forming PVM is observationally equivalent to the PVM augmented with persistent transitory consumption, which is induced by world real interest rate shocks. Based on a small open-economy real business cycle (SOE-RBC) model endowed with consumption habits as well as persistent world real interest rate shocks, this paper resolves the inherent identification problem of the habit-forming PVM by Bayesian methods to seek effects of habit formation on current account fluctuations in typical small open economies, Canada and the United Kingdom. Results reveal no clear evidence that habit formation plays a crucial role in current account fluctuations.