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How Does Financial Repression/Liberalization Affect the Response of the Current Account to Output Shocks?

In this subsection we derive robust identification restrictions and examine how the current account reacts to net output shocks at different levels of financial repression (the liquidity constraint) in our theoretical model. In order to understand how the current account reacts to net output shocks at different levels of financial repression/ liberalization, we need to make further assumptions on the stochastic process driving net output (lnNOt). Net output can be subject to shocks in log-differences, AlnNO, = pAlnNO,_ j + e„ or log-levels, lnNOt = plnNO, _ j + et. A priori, it is not feasible to know which process is driving the log of net output. We will therefore consider both of them and examine the effect of an unexpected shock to either net output process on the current account individually. At this point, most previous work would solve the model numerically and show that those theoretical impulse responses, from which the sign identification restrictions are derived, are robust to many different possible parameter values (see Enders et al. 2011, for more details on this approach.). We choose a different route. The advantage of our approach is that we can demonstrate the robustness of our identification restrictions and theoretical predictions analytically.

In the case of external habitual consumption and net output log- difference shocks, one can then show that (see appendix) Eq. (8.8) becomes

It is then easy to see that:

as long as у , P , h , к and ?0,1) and к > у, which will be satisfied under any plausible parameterization of this model. Since к = exp ($ — p) and $ — p is unlikely to be large, Kano (2008) argues that к should be fairly close to, but smaller than, one. We therefore assume that к E 0.9,1) Since у , the fraction of the population that is liquidity constrained, is unlikely to exceed this lower bound in reality, the condition к > у will always be satisfied for any plausible parameterization of the model. Given these parameter restrictions, one can clearly see that the impact response of a log-difference net output shock upon impact is negative and that greater liquidity constraints make the impact response of this shock less negative, thus smaller. In other words, financial liberalization, i.e. the removal of liquidity constraints, makes the response of the current account to a log-difference net output shock larger. Since the coefficient on cat- x is a function of у one can also clearly see that the effect of a past shock on the current account today declines with a greater fraction of liquidity-constrained agents. This means that the persistence of the current account is also decreasing in the liquidity constraint. In the case of log-level net output shocks equation (8.8) becomes

It is then easy to show that дСй > 0 and дСй < 0, meaning that a

det detdy

positive log-level net output shock leads to an increase in the current account to net output ratio. The corresponding identification restrictions and predictions from a model with internal, as opposed to external, habits are almost identical, with the difference that liquidity constraints no longer affect current account persistence. This is because with internal habits, the consumption of decisions of Ricardian agents are a function of their own, rather than the economy average, past consumption. In short, the model predicts that with smaller liquidity constraints (financial liberalization), the response of the current account becomes larger in any case, and more persistent in the presence of external habits, for a given log-level (difference) net output shock. This is the hypothesis that we seek to test empirically in this chapter.

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