What is the current account response to a transitory income shock? This model predicts that favorable income shocks lead to current account deficits in debtor countries and current account surpluses in creditor countries.
Kraay and Ventura reexamine a classic question in international economics: What is the current account response to a transitory income shock such as a temporary improvement in the terms of trade, a transfer from abroad, or unusually high production?
To answer this question, they construct a world equilibrium model in which productivity varies across countries and international borrowing and lending take place to exploit good investment opportunities.
Despite its conventional ingredients, the model generates the novel prediction that favorable income shocks lead to current account deficits in debtor countries and current account surpluses in creditor countries. Evidence from thirteen OECD countries broadly supports this theoretical prediction.
This paper—a product of the Macroeconomics and Growth Division, Development Research Group—is part of a larger effort in the group to study open-economy macroeconomics. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rebecca Martin, room N11-059, telephone 202-473-9026, fax 202-522-3518, Internet address rmartin1@worldbank.org. (55 pages)
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