Investment and the Current Account in the Short Run and the Long Run

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 647 October 1999 INVESTMENT AND THE CURRENT ACCOUNT IN THE SHORT RUN AND THE LONG RUN James M. Nason and John H. Rogers NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.bog.frb.fed.us.

Investment and the Current Account in the Short Run and the Long Run James M. Nason and John H. Rogers* Abstract: Theoretical models of the relationship between investment and the current account impose restrictions on the joint dynamic behavior of these variables. These restrictions come in two forms. One imposes causal orderings on investment and the current account. The other restriction concerns the permanent responses of these variables to different shocks. We use these restrictions to identify empirically structural shocks from vector autoregressions of investment and the current account for Canada. Under certain identifications, our results support the implications of the intertemporal, small open economy model. However, these results are sensitive to perturbations of the identifications. *The first author is an Associate Professor of Economics at the University of British Columbia. He can be reached at Department of Economics, University of British Columbia, 1873 East Mall, Vancouver, British Columbia, CANADA V6T 1Z1. The second author is a senior economist in the International Finance Division of the Federal Reserve Board. He can be reached at Mail Stop 22, Federal Reserve Board, Washington, D.C. 20551. email: nason@econ.ubc.ca and john.h.rogers@FRB.GOV. We thank Mick Devereux Enrique Mendoza, Jaume Ventura, seminar participants at the Research Triangle Econometrics Workshop, Duke University, and Virginia Tech, and especially Mark Watson. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

1 . I n t r o d u c t i o n S i n c e t h e o i l p r i c e s h o c k s o f t h e 1 9 7 0 s , a t t e m p t s t o e x p l a i n t h e s e e m i n g l y a b e r r a n t b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t i n t h e G r o u p o f S e v e n ( G (cid:0) 7 ) e c o n o m i e s h a v e d r i v e n e c o n o m i s t s t o d i s t r a c t i o n . T o e x p l a i n t h i s b e h a v i o r , t h e l i t e r a t u r e e m p h a s i z e s t h e r e s p o n s e s o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t t o a v a r i e t y o f s h o c k s g i v e n d i (cid:11) e r e n t t e c h n o l o g y , u t i l i t y , a s s e t m a r k e t , a n d i n f o r m a t i o n a l s t r u c t u r e s . O f t e n , t h e l i t e r a t u r e j u d g e s t h e s u c c e s s o f t h e s e e x p l a n a t i o n s w i t h i n t h e f r a m e w o r k o f t h e i n t e r t e m p o r a l , s m a l l o p e n 1 e c o n o m y m o d e l . G l i c k a n d R o g o (cid:11) ( 1 9 9 5 ) p r o v i d e a l e a d i n g e x a m p l e o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y a p p r o a c h t o s t u d y i n g t h e j o i n t d y n a m i c b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . T h e t a s k G l i c k a n d R o g o (cid:11) s e t f o r t h e m s e l v e s i s t o p r o v i d e s o m e t h e o r e t i c a l c o n t e n t t o t h e c o n (cid:13) i c t i n g c l a i m s o f F e l d s t e i n a n d H o r i o k a ( 1 9 8 0 ) a n d S a c h s ( 1 9 8 1 ) , a m o n g o t h e r s , t h a t c o n c e r n t h e d e g r e e o f i n t e r n a t i o n a l c a p i t a l m o b i l i t y d u r i n g t h e p o s t - w a r p e r i o d . F e l d s t e i n a n d H o r i o k a c l a i m t h a t t h e o b s e r v e d p o s i t i v e c o r r e l a t i o n s b e t w e e n s a v i n g a n d i n v e s t m e n t a c r o s s i n d u s t r i a l i z e d e c o n o m i e s c a n o n l y b e e x p l a i n e d b y t h e i s o l a t i o n o f n a t i o n a l c a p i t a l m a r k e t s . S a c h s r e p o r t s a n e g a t i v e c o r r e l a t i o n b e t w e e n c h a n g e s i n t h e c u r r e n t a c c o u n t a n d c h a n g e s i n i n v e s t m e n t a n d a r r i v e s a t t h e o p p o s i t e c o n c l u s i o n . T h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l y i e l d s a n e x p l i c i t p r e d i c t i o n a b o u t t h e c o r r e l a t i o n o f t h e c u r r e n t a c c o u n t a n d i n v e s t m e n t o n l y g i v e n a s p e c i (cid:12) c c o l l e c t i o n o f r e s t r i c t i o n s . F o r e x a m p l e , a s s u m i n g p e r f e c t c a p i t a l m o b i l i t y , i f t h e o n l y s o u r c e o f u n c e r t a i n t y i n t h e m o d e l i s a c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k a n d t h i s s h o c k h a s p e r m a n e n t e (cid:11) e c t s , t h e m o d e l p r e d i c t s t h a t t h e c o r r e l a t i o n b e t w e e n t h e c u r r e n t a c c o u n t a n d i n v e s t m e n t e q u a l s n e g a t i v e o n e . A s G l i c k a n d R o g o (cid:11) a n d o t h e r s n o t e , w i t h o u t t h e s e r e s t r i c t i o n s , t h e i n t e r t e m p o r a l 2 m o d e l p r e d i c t s t h a t t h i s c o r r e l a t i o n c a n t a k e o n a n y v a l u e b e t w e e n z e r o a n d n e g a t i v e o n e . G l i c k a n d R o g o (cid:11) r e p o r t a c o r r e l a t i o n b e t w e e n t h e c h a n g e i n t h e c u r r e n t a c c o u n t a n d t h e c h a n g e i n i n v e s t m e n t o f (cid:0) 0 : 3 9 f o r t h e G (cid:0) 7 d u r i n g t h e p o s t - 1 9 7 5 p e r i o d . A t (cid:12) r s t g l a n c e , t h i s c o r r e l a t i o n i s p u z z l i n g i n l i g h t o f w h a t a p p e a r s t o b e o p e n c a p i t a l m a r k e t s . T o e x p l a i n t h i s p u z z l e , G l i c k a n d R o g o (cid:11) a r g u e t h a t i f v a r i a t i o n i n t h e w o r l d t e c h n o l o g y s h o c k i s l a r g e , t h e o r y p r e d i c t s t h a t t h e c o r r e l a t i o n o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t i s l a r g e r t h a n n e g a t i v e o n e ( i . e . , c l o s e r t o z e r o ) (cid:0) e v e n w i t h p e r f e c t c a p i t a l m o b i l i t y . G l i c k a n d R o g o (cid:11) ’ s c a l c u l a t i o n s s u g g e s t t h a t v a r i a t i o n i n t h e w o r l d t e c h n o l o g y s h o c k i s i n d e e d l a r g e . F o r t h e t y p i c a l G (cid:0) 7 e c o n o m y , t h e i r c a l c u l a t i o n s s h o w t h a t t h e w o r l d t e c h n o l o g y s h o c k a c c o u n t s f o r 3 n e a r l y o n e - h a l f o f t h e v a r i a t i o n i n t o t a l p r o d u c t i v i t y . 1 O b s t fe ld a n d R o g o (cid:11) ( 1 9 9 5 ) p r o v id e a n e x c e lle n t r e v ie w o f t h is r e s e a r c h . 2 O b s t fe ld ( 1 9 8 6 ) , C a r d ia ( 1 9 9 1 ) , a n d M e n d o z a ( 1 9 9 1 , 1 9 9 3 ) d is c u s s r e a s o n s fo r t h e c o n fu s io n s u r r o u n d in g in t e r p r e t a t io n s o f t h e c o r r e la t io n o f in v e s t m e n t a n d s a v in g ( o r t h e c u r r e n t a c c o u n t ) . 3 T h e t w o - c o u n t r y r e a l b u s in e s s c y c le ( R B C ) m o d e l t h a t B a x t e r a n d C r u c in i ( 1 9 9 3 ) s t u d y t y p i(cid:12) e s a n o t h e r p a t h t h e lit e r a t u r e h a s t a k e n . A c c o r d in g t o B a x t e r a n d C r u c in i, t h e la r g e p o s it iv e c o r r e la t io n b e t w e e n s a v in g a n d in v e s t m e n t c a n b e e x p la in e d b y p o s it iv e ly c o r r e la t e d p r o d u c t iv it y s h o c k s a c r o s s e c o n o m ie s . G lic k a n d R o g o (cid:11) ’s e x p la n a t io n is in t h is s p ir it . T e s a r ( 1 9 9 1 ) a ls o e x a m in e s t h is is s u e , a d d in g a n o n - t r a d a b le g o o d s e c t o r t o t h e t w o - c o u n t r y R B C m o d e l. S in c e t h is s e c t o r in t r o d u c e s c o u n t r y - s p e c i(cid:12) c r is k t h a t c a n n o t b e d iv e r s i(cid:12) e d , it r e s u lt s in s m a lle r c o r r e la t io n s b e t w e e n a g g r e g a t e q u a n t it ie s a c r o s s e c o n o m ie s . 1

m a t i s c s a O j a t ( t r t a a t s w t j p l i h t c i n c o w i t G l i c k a n d R o g o (cid:11) g o o n t o u n c o v e r a n e w p u z z l e . A c c o r d i n g t o t h e i n t e r t e m p o r a l o d e l , a p e r m a n e n t c o u n t r y - s p e c i (cid:12) c p r o d u c t i v i t y s h o c k h a s a l a r g e r e (cid:11) e c t o n t h e c u r r e n t c c o u n t t h a n o n i n v e s t m e n t . S i n c e p e r m a n e n t i n c o m e r i s e s a b o v e c u r r e n t i n c o m e f o l l o w i n g h e s h o c k , d o m e s t i c s a v i n g f a l l s , a n d t h e c u r r e n t a c c o u n t ( e q u a l t o d o m e s t i c s a v i n g l e s s n v e s t m e n t ) f a l l s b y m o r e t h a n i n v e s t m e n t r i s e s . H o w e v e r , G l i c k a n d R o g o (cid:11) (cid:12) n d t h a t c o u n t r y p e c i (cid:12) c t e c h n o l o g y s h o c k s a (cid:11) e c t i n v e s t m e n t b y t w o o r t h r e e t i m e s m o r e t h a n t h e y a (cid:11) e c t t h e u r r e n t a c c o u n t . T h e a u t h o r s o (cid:11) e r a r e s o l u t i o n t o t h i s p u z z l e b y a r g u i n g t h a t t h e c o u n t r y p e c i (cid:12) c t e c h n o l o g y s h o c k f o l l o w s a n e a r r a n d o m w a l k r a t h e r t h a n a r a n d o m w a l k . I n t h i s p a p e r , w e e x a m i n e t h e j o i n t d y n a m i c b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t c c o u n t , i n o r d e r t o e m p i r i c a l l y e v a l u a t e t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . n e o f t h e i s s u e s w e c o n f r o n t i s h o w t o t r a n s l a t e d i (cid:11) e r e n t a s p e c t s o f t h e m o d e l i n t o a u s t - i d e n t i (cid:12) e d S V A R . F o r e x a m p l e , G l i c k a n d R o g o (cid:11) ’ s r e s u l t s s u g g e s t a n i d e n t i (cid:12) c a t i o n f o r n e m p i r i c a l v e r s i o n o f t h e m o d e l w i t h t h e f o l l o w i n g r e s t r i c t i o n s : ( i ) t h e c o m m o n , w o r l d e c h n o l o g y s h o c k i s i n t e g r a t e d ; ( i i ) t h e c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k i s s t a t i o n a r y ; i i i ) i n v e s t m e n t i s c a u s a l l y p r i o r t o t h e c u r r e n t a c c o u n t , a n d ( i v ) i n n o v a t i o n s i n t h e w o r l d e c h n o l o g y s h o c k d o n o t m a t t e r f o r c h a n g e s i n t h e c u r r e n t a c c o u n t . T a k e n t o g e t h e r , t h e s e e s t r i c t i o n s y i e l d a n o v e r - i d e n t i (cid:12) e d S V A R o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . R a t h e r t h a n w o r k w i t h t h i s c o l l e c t i o n o f o v e r - i d e n t i f y i n g r e s t r i c t i o n s a n d t h e l i m i t a i o n s i t i m p l i e s , w e e m p l o y o t h e r S V A R m e t h o d s t h a t c a n p o t e n t i a l l y r e v e a l m o r e i n f o r m a t i o n b o u t t h e j o i n t d y n a m i c b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . W e u s e d i (cid:11) e r e n t s p e c t s o f t h e i n t e r t e m p o r a l m o d e l t o c o n s t r u c t s e v e r a l j u s t - i d e n t i (cid:12) e d s t r u c t u r a l v e c t o r a u o r e g r e s s i o n s ( S V A R s ) o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . O u r s t r a t e g y c o n s i s t s o f t w o t e p s . F i r s t , w e i m p o s e e n o u g h r e s t r i c t i o n s t o j u s t - i d e n t i f y t h e S V A R . I n t h e s e c o n d s t e p , e a s k i f r e s u l t s f r o m t h e e s t i m a t e d m o d e l a r e c o n s i s t e n t w i t h t h o s e p r e d i c t i o n s o f t h e i n a p r i o r i e r t e m p o r a l m o d e l t h a t w e r e n o t i m p o s e d . T h i s p r o c e s s l e a d s u s t o c o n s t r u c t s i x u s t - i d e n t i (cid:12) e d S V A R s o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . G e n e r a l l y , o u r i d e n t i (cid:12) c a t i o n r e s t r i c t i o n s c o m e i n t w o f o r m s . T h e (cid:12) r s t c o n c e r n s t h e e r m a n e n t r e s p o n s e s o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t t o d i (cid:11) e r e n t s h o c k s . O u r p a r t i c u a r i n t e r e s t c e n t e r s o n t h e r e s p o n s e o f o n e o f t h e v a r i a b l e s t o a p e r m a n e n t o n e u n i t m o v e m e n t n t h e o t h e r v a r i a b l e . T h e s e l o n g - r u n m u l t i p l i e r r e s p o n s e s y i e l d i n f o r m a t i o n a b o u t t h e b e a v i o r o f e i t h e r i n v e s t m e n t o r t h e c u r r e n t a c c o u n t w i t h r e s p e c t t o a p e r m a n e n t m o v e m e n t i n h e i d e n t i (cid:12) e d s h o c k . F o r e x a m p l e , w h e n w e i m p o s e t h e r e s t r i c t i o n t h a t t h e r e s p o n s e o f t h e u r r e n t a c c o u n t t o a o n e u n i t p e r m a n e n t i n c r e a s e i n i n v e s t m e n t e q u a l s z e r o , t h e i d e n t i (cid:12) c a t i o n m p o s e s a n e c e s s a r y c o n d i t i o n o f t h e i n t e r t e m p o r a l m o d e l (cid:0) t h a t t h e c u r r e n t a c c o u n t d o e s o t r e s p o n d t o c o m m o n , w o r l d s h o c k s . W e l a b e l t h i s i d e n t i (cid:12) c a t i o n R 1 . T h e s e c o n d t y p e o f r e s t r i c t i o n c o n c e r n s t h e c o n t e m p o r a n e o u s i n t e r a c t i o n b e t w e e n h a n g e s i n t h e c u r r e n t a c c o u n t a n d c h a n g e s i n i n v e s t m e n t . S i n c e t h e i n t e r t e m p o r a l , s m a l l p e n e c o n o m y m o d e l m a i n t a i n s t h a t c u r r e n t a c c o u n t (cid:13) u c t u a t i o n s a r e i n d e p e n d e n t o f c o m m o n o r l d s h o c k s , t h e p r e d i c t e d i m p a c t r e s p o n s e o f a c h a n g e i n t h e c u r r e n t a c c o u n t t o a c h a n g e n i n v e s t m e n t e q u a l s z e r o . A s i n t h e c a s e o f R 1 , t h i s r e s t r i c t i o n i s a n e c e s s a r y c o n d i t i o n o f h e i n t e r t e m p o r a l m o d e l . W e g i v e t h i s i d e n t i (cid:12) c a t i o n t h e l a b e l R 3 . 2

T a w t i W c r b m b i s i t i s p t o i e a i s v t e a h r T h e m e t h o d s w e u s e t o e s t i m a t e t h e S V A R s f o l l o w t h o s e o f K i n g a n d W a t s o n ( 1 9 9 7 ) . h e y s t u d y t h e s h o r t - r u n a n d l o n g - r u n i n t e r a c t i o n s b e t w e e n n o m i n a l a n d r e a l v a r i a b l e s u n d e r v a r i e t y o f a s s u m p t i o n s a b o u t e i t h e r i m p a c t r e s p o n s e s o r l o n g - r u n m u l t i p l i e r s . W e b e g i n i t h a d y n a m i c , s i m u l t a n e o u s e q u a t i o n s s y s t e m t h a t c o n s i s t s o f t h e c h a n g e i n i n v e s t m e n t a n d h e c h a n g e i n t h e c u r r e n t a c c o u n t . S i n c e t h i s d y n a m i c s y s t e m i s d e r i v e d f r o m a s t o c h a s t i c , n t e r t e m p o r a l s m a l l o p e n e c o n o m y m o d e l , t h e s y s t e m p o s s e s s e s a s t r u c t u r a l i n t e r p r e t a t i o n . e e m p l o y t h i s m o d e l t o s t u d y t h e s h o r t - r u n a n d l o n g - r u n r e s p o n s e s o f i n v e s t m e n t a n d t h e u r r e n t a c c o u n t t o v a r i o u s i d e n t i (cid:12) c a t i o n s i m p o s e d o n t h e d y n a m i c s y s t e m . W e f o c u s o n C a n a d a , a p r o t o - t y p e s m a l l o p e n e c o n o m y , b u t n o t e t h a t m o s t o f o u r 4 e s u l t s h o l d f o r t h e r e s t o f t h e G (cid:0) 7 . A l t h o u g h w e (cid:12) n d t h a t s o m e o f t h e r e s u l t s g e n e r a t e d y a n y p a r t i c u l a r i d e n t i (cid:12) c a t i o n s u p p o r t a s p e c t s o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y o d e l , t h e e x t e n t o f t h i s s u p p o r t v a r i e s a c r o s s S V A R s p e c i (cid:12) c a t i o n s . W e h a v e f o u r m a i n r e s u l t s . F i r s t , m o s t o f o u r e s t i m a t e s i n d i c a t e t h a t i n v e s t m e n t o o m s a r e a s s o c i a t e d w i t h c u r r e n t a c c o u n t d e (cid:12) c i t s . S e c o n d , a l l i d e n t i (cid:12) c a t i o n s i n d i c a t e t h a t n t h e l o n g r u n o n l y p e r m a n e n t m o v e m e n t s i n w o r l d s h o c k s m a t t e r f o r i n v e s t m e n t . T h i r d , t h e i z e a n d s i g n o f t h e i m p a c t r e s p o n s e o f t h e c u r r e n t a c c o u n t t o i n v e s t m e n t ( o r w o r l d s h o c k s ) s s e n s i t i v e t o t h e i d e n t i (cid:12) c a t i o n . F i n a l l y , t h e c u r r e n t a c c o u n t e x h i b i t s a p e r s i s t e n t r e s p o n s e o m o v e m e n t s i n c o u n t r y - s p e c i (cid:12) c s h o c k s t h a t i s s t a t i s t i c a l l y s i g n i (cid:12) c a n t a n d e c o n o m i c a l l y m p o r t a n t . A s w e d i s c u s s b e l o w , t h e (cid:12) r s t t w o r e s u l t s a r e c o n s i s t e n t w i t h t h e i n t e r t e m p o r a l , m a l l o p e n e c o n o m y m o d e l . H o w e v e r , t h e (cid:12) n a l r e s u l t , t h a t t h e c u r r e n t a c c o u n t e x h i b i t s a e r s i s t e n t r e s p o n s e t o m o v e m e n t s i n c o u n t r y - s p e c i (cid:12) c s h o c k s , c o n t r a d i c t s a c e n t r a l t e n e t o f h e i n t e r t e m p o r a l m o d e l . O u r e m p i r i c a l r e s u l t s t h u s s e r v e a s a r e m i n d e r o f t h e l i m i t a t i o n s f t h a t m o d e l a s a n e x p l a n a t i o n o f c u r r e n t a c c o u n t (cid:13) u c t u a t i o n s . T h e n e x t s e c t i o n d i s c u s s e s t h e m e t h o d s w e u s e t o c o n s t r u c t a n d c o m p u t e t h e S V A R s , n c l u d i n g d i s c u s s i o n o f t h e i d e n t i f y i n g r e s t r i c t i o n s . W e d e s c r i b e t h e d a t a a n d p r e s e n t o u r s t i m a t e s i n s e c t i o n 3 . C o n c l u s i o n s a r e c o n t a i n e d i n s e c t i o n 4 . 2 . A S t r u c t u r a l V A R A p p r o a c h N e o c l a s s i c a l t h e o r y m a k e s s e v e r a l p r e d i c t i o n s r e g a r d i n g t h e r e s p o n s e s o f i n v e s t m e n t n d t h e c u r r e n t a c c o u n t t o d i (cid:11) e r e n t t y p e s o f s h o c k s i n a s m a l l o p e n e c o n o m y . O n e p r e d i c t i o n s t h a t t h e c u r r e n t a c c o u n t d o e s n o t r e s p o n d t o c o m m o n , w o r l d s h o c k s , o n l y t o c o u n t r y - 5 p e c i (cid:12) c s h o c k s . I n a d y n a m i c c o n t e x t , t h i s p l a c e s r e s t r i c t i o n s o n t h e c o e (cid:14) c i e n t s o f t h e e c t o r m o v i n g a v e r a g e ( V M A ) p r o c e s s o f t h e c h a n g e i n i n v e s t m e n t , (cid:1) I , a n d t h e c h a n g e i n t h e c u r r e n t a c c o u n t , (cid:1) C A . C o n s t r u c t i n g t e s t s o f t h e s e r e s t r i c t i o n s i s n o t a s t r a i g h t f o r w a r d t c o n o m e t r i c e x e r c i s e . I f a s t r u c t u r a l m o d e l b a s e d o n o p t i m i z i n g b e h a v i o r i s n o t a v a i l a b l e , i t 4 T h e s e r e s u lt s a r e a v a ila b le o n r e q u e s t in a n a p p e n d ix t o t h is p a p e r . 5 O b s t fe ld a n d R o g o (cid:11) ( 1 9 9 5 ) d is c u s s t h a t w h e n a s h o c k a (cid:11) e c t s a ll e c o n o m ie s in t h e s a m e w a y , n o g a in s t o lt e r in g in t e r t e m p o r a l a llo c a t io n s e x is t . A ll t h a t o c c u r s is t h e w o r ld r e a l in t e r e s t r a t e a d ju s t s . O n t h e o t h e r a n d , a c o u n t r y - s p e c i(cid:12) c s h o c k g e n e r a t e s g a in s t o c h a n g in g in t e r t e m p o r a l a llo c a t io n s b e c a u s e t h e d o m e s t ic e a l in t e r e s t r a t e , a s d e (cid:12) n e d b y t h e m a r g in a l r a t e o f s u b s t it u t io n , d i(cid:11) e r s fr o m t h e w o r ld r e a l in t e r e s t r a t e . 3

i s d i (cid:14) c u l t t o i m p u t e s t r u c t u r a l c o n t e n t t o r e s u l t s o b t a i n e d f r o m a b i v a r i a t e a u t o r e g r e s s i o n o f (cid:1) I a n d (cid:1) C A . t t T o n a v i g a t e o u r w a y a r o u n d t h e s e p r o b l e m s , w e a d a p t m e t h o d s K i n g a n d W a t s o n ( 1 9 9 7 ) d e v e l o p . T h e s e a u t h o r s e x p l o r e t h e i m p l i c a t i o n s f o r v a r i o u s l o n g - r u n n e u t r a l i t y p r o p o s i t i o n s u s i n g b i v a r i a t e S V A R s . B y i m p o s i n g d i (cid:11) e r e n t i d e n t i f y i n g r e s t r i c t i o n s o n a S V A R o f o u t p u t a n d m o n e y , t h e y a r e a b l e t o a s k w h i c h i d e n t i f y i n g r e s t r i c t i o n s a r e c o n s i s t e n t w i t h l o n g - r u n m o n e t a r y n e u t r a l i t y . I n t h i s w a y , t h e y g e n e r a t e i n f o r m a t i o n a b o u t t h e n e u t r a l i t y 6 p r o p o s i t i o n f o r a c o l l e c t i o n o f d i (cid:11) e r e n t i d e n t i f y i n g a s s u m p t i o n s . T h i s p e r m i t s a n a s s e s s m e n t o f t h e v a l i d i t y o f t h e n e u t r a l i t y p r o p o s i t i o n c o n d i t i o n a l o n t h e r e s t r i c t i o n s r e q u i r e d t o p r o d u c e i t . B y a n a l o g y , w e u s e u s e d i (cid:11) e r e n t a s p e c t s o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l t o c o n s t r u c t s i x j u s t - i d e n t i (cid:12) e d S V A R s o f (cid:1) I a n d (cid:1) C A a n d a s s e s s t h e p r e d i c t i o n s o f t t t h e i n t e r t e m p o r a l m o d e l b a s e d o n t h e e s t i m a t e d S V A R s . A k e y a s s u m p t i o n o f t h e K i n g a n d W a t s o n ( 1 9 9 7 ) S V A R m e t h o d s i s t h a t t h e o b s e r v a b l e v a r i a b l e s o f t h e V M A p r o c e s s a r e i n t e g r a t e d . O u r l o n g - r u n n e u t r a l i t y t e s t i n v o l v e s e x a m i n i n g t h e p e r m a n e n t r e s p o n s e , o f s a y , t h e c u r r e n t a c c o u n t t o a p e r m a n e n t a n d u n a n t i c i p a t e d c h a n g e i n i n v e s t m e n t . W h e n w e (cid:12) n d t h i s r e s p o n s e t o b e e i t h e r e c o n o m i c a l l y o r s t a t i s t i c a l l y u n i m p o r t a n t , w e c a n s t a t e t h a t t h e c u r r e n t a c c o u n t i s i n d e p e n d e n t o f t h e s o u r c e s o f p e r m a n e n t (cid:13) u c t u a t i o n s i n i n v e s t m e n t . H o w e v e r , o u r a n a l y s i s d e p e n d s o n t h e w a y i n w h i c h w e i d e n t i f y b o t h t h e p e r m a n e n t c o m p o n e n t o f i n v e s t m e n t a n d t h e c o n n e c t i o n b e t w e e n t h e c u r r e n t a c c o u n t a n d t h e p e r m a n e n t c o m p o n e n t o f i n v e s t m e n t . 2 . 1 S o m e E c o n o m e t r i c s o f t h e I n t e r t e m p o r a l , S m a l l O p e n E c o n o m y M o d e l T h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l t h a t G l i c k a n d R o g o (cid:11) ( 1 9 9 5 ) c o n s t r u c t s e r v e s a s a n e x a m p l e t o m o t i v a t e t h e s e i d e a s . I n a m o d e l i n w h i c h h o u s e h o l d s u s e t h e p e r m a n e n t i n c o m e h y p o t h e s i s c o n s u m p t i o n r u l e , (cid:12) r m s m a x i m i z e t h e p r e s e n t d i s c o u n t e d v a l u e o f n e t p r o (cid:12) t s s u b j e c t t o a d j u s t m e n t c o s t s i n t h e c a p i t a l s t o c k , a n d w o r l d a n d c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k s f o l l o w r a n d o m w a l k s , G l i c k a n d R o g o (cid:11) g e n e r a t e t h e d e c i s i o n r u l e f o r t h e l e v e l o f i n v e s t m e n t 1 1 2 3 I = (cid:30) I + (cid:30) (cid:1) A + (cid:30) (cid:1) A ; ( 1 ) t t(cid:0) C ;t W ;t a n d s h o w t h a t t h e l e v e l o f t h e c u r r e n t a c c o u n t f o l l o w s 1 1 2 1 C A = ’ I + ’ (cid:1) A + r C A ; ( 2 ) t t(cid:0) C ;t t(cid:0) w h e r e A ; A , a n d r d e n o t e t h e l e v e l o f t h e w o r l d t e c h n o l o g y s h o c k , t h e l e v e l o f t h e W ;t C ;t 7 c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k , a n d t h e c o n s t a n t w o r l d r e a l i n t e r e s t r a t e , r e s p e c t i v e l y . T h e i n n o v a t i o n s t o t h e t e c h n o l o g y s h o c k s A a n d A a r e a s s u m e d t o b e u n c o r r e l a t e d a t W ;t C ;t 6 J e (cid:11) e r s o n ( 1 9 9 7 ) p r e s e n t s r e s u lt s a b o u t t h e s h o r t - r u n a n d lo n g - r u n n e u t r a lit y o f in s id e a n d o u t s id e m o n e y fo r t h e U .S . u s in g s im ila r m e t h o d s . 7 1 2 3 1 2 (cid:30) ; (cid:30) ; (cid:30) ; ’ ’ T h e s e a r e e q u a t io n s ( 1 5 ) a n d ( 1 7 ) in G lic k a n d R o g o (cid:11) . T h e c o e (cid:14) c ie n t s , , a n d , a r e n o n lin e a r fu n c t io n s o f t h e t e c h n o lo g y a n d p r e fe r e n c e p a r a m e t e r s o f t h e ir s m a ll o p e n e c o n o m y m o d e l. 4

a e t v c ( m o i l r w t o (cid:1) o p e j i c o r m a F m c i o t s l l l e a d s a n d l a g s . T h e c h a n g e i n t h e l e v e l o f t h e w o r l d t e c h n o l o g y s h o c k d o e s n o t a p p e a r i n q u a t i o n ( 2 ) b e c a u s e o f t h e s m a l l o p e n e c o n o m y a s s u m p t i o n . T h e r e a r e s e v e r a l w a y s t o e s t i m a t e t h e r e s p o n s e s o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t o d i (cid:11) e r e n t t y p e s o f s h o c k s . T r e a t i n g A a n d A a s o b s e r v a b l e , G l i c k a n d R o g o (cid:11) e s t i m a t e W ;t C ;t a r i a n t s o f e q u a t i o n s ( 1 ) a n d ( 2 ) . A n o t h e r w a y i s t o c o m b i n e e q u a t i o n s ( 1 ) a n d ( 2 ) a n d t o o n s t r u c t t h e r e d u c e d f o r m r e l a t i o n s h i p 2 1 3 ’ (cid:30) (cid:30) 1 1 1 1 2 2 (cid:1) A + r C A : 3 ) C A = ’ + ( 1 (cid:0) (cid:30) ) I (cid:0) ’ (cid:0) ’ (cid:1) I (cid:0) ’ W ;t t(cid:0) t t t 2 2 2 (cid:30) (cid:30) (cid:30) " # " # F r o m e q u a t i o n ( 3 ) , w e c a n e v a l u a t e t h e s h o r t - r u n a n d l o n g - r u n r e s p o n s e s o f C A t o t 8 1 o v e m e n t s i n A w h e n w e t r e a t C A a s a p r e - d e t e r m i n e d v a r i a b l e . T h e d i r e c t i m p a c t W ;t t(cid:0) 2 3 2 n C A o f a t r a n s i t o r y c h a n g e i n A e q u a l s (cid:0) ’ (cid:30) = (cid:30) . H o w e v e r , (cid:1) A h a s a n i n d i r e c t t W ;t W ;t m p a c t o n C A t h r o u g h (cid:1) I . T h i s i s m e a s u r e d b y t h e t e r m i n b r a c k e t s a t t a c h e d t o (cid:1) I . T h e t t t o n g - r u n i m p a c t o f a p e r m a n e n t c h a n g e i n A o n C A c o m e s a b o u t b e c a u s e o f t h e l o n g r u n W ;t t e l a t i o n s h i p b e t w e e n A a n d I . S i n c e e q u a t i o n ( 1 ) p r e d i c t s t h a t I p o s s e s s e s a u n i t r o o t W ;t t t h e n A d o e s , w e c a n o b t a i n t h e l o n g - r u n r e s p o n s e o f C A t o a p e r m a n e n t c h a n g e i n A W ;t t W ;t h r o u g h t h e r e l a t i o n s h i p b e t w e e n C A a n d I i n e q u a t i o n ( 3 ) . t t T h e c o n s i s t e n c y o f e s t i m a t e s o f e q u a t i o n ( 3 ) d e p e n d s o n w h e t h e r t h e e c o n o m e t r i c i a n b s e r v e s A . W h e n w e t r e a t A a s u n o b s e r v a b l e , a n O L S r e g r e s s i o n o f C A o n I a n d W ;t W ;t t t I p r o d u c e s b i a s e d e s t i m a t e s o f t h e s h o r t r u n a n d l o n g - r u n r e s p o n s e s o f C A t o A . T h i s t t W ;t c c u r s b e c a u s e I a n d (cid:1) I a r e c o r r e l a t e d w i t h t h e e r r o r t e r m o f t h e r e g r e s s i o n . A l t h o u g h t h i s t t r o b l e m c a n b e h a n d l e d w i t h a n i n s t r u m e n t a l v a r i a b l e s ( I V ) e s t i m a t o r , t h e r e d u c e d f o r m 9 q u a t i o n ( 3 ) i s l i m i t e d b e c a u s e i t p o s s e s s e s s i m p l e d y n a m i c s a n d o n l y t e c h n o l o g y s h o c k s . W e t a k e a i m a t a w i d e r t a r g e t i n t h i s p a p e r . I n p a r t i c u l a r , o u r g o a l i s t o c o n s t r u c t u s t - i d e n t i (cid:12) e d S V A R s o f I a n d C A u s i n g t h e r e s t r i c t i o n s a n d s h o c k s t h a t a r i s e f r o m t h e t t n t e r t e m p o r a l m o d e l . T h e e s t i m a t e s y i e l d d y n a m i c r e s p o n s e s o f I a n d C A t o t h e s h o c k s , t t o n d i t i o n a l o n t h e r e s t r i c t i o n s t h e j u s t - i d e n t i (cid:12) e d s t r u c t u r e r e q u i r e s . T h i s a p p r o a c h e x t e n d s u r e m p i r i c a l a n a l y s i s b e y o n d t h e r e d u c e d f o r m r e l a t i o n s h i p o f e q u a t i o n ( 3 ) . S i n c e m a n y e c e n t i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l s p o s i t t h a t s h o c k s b e s i d e s A a n d A W ;t C ;t a t t e r f o r c u r r e n t a c c o u n t (cid:13) u c t u a t i o n s , w e a l l o w t h e e r r o r s t r u c t u r e o f o u r S V A R t o c o n t a i n l a r g e r v a r i e t y o f s h o c k s t h a t i n c l u d e s , f o r e x a m p l e , t a s t e , (cid:12) s c a l , a n d m o n e t a r y s h o c k s . u r t h e r , w e i n t r o d u c e g e n e r i c d y n a m i c s t o c a p t u r e a s p e c t s o f m o n o p o l i s t i c c o m p e t i t i o n , e n u c o s t s , i m p e r f e c t i n f o r m a t i o n , a n d g e n e r a l i z e d c o s t o f a d j u s t m e n t f u n c t i o n s . O u r S V A R a n h a n d l e t h e s e v a r i a t i o n s o n t h e b a s i c i n t e r t e m p o r a l m o d e l w i t h o u t a n y e (cid:11) e c t o n t h e n t e r p r e t a t i o n o f t h e e s t i m a t e s o f t h e i m p a c t a n d l o n g - r u n r e s p o n s e s o f I a n d t h e C A . t t W e c o n s i d e r a m o d e l t h a t i s l i n e a r i n t h e o b s e r v a b l e s , (cid:1) I a n d (cid:1) C A , a n d t h e u n - t t b s e r v e d s t r u c t u r a l s h o c k i n n o v a t i o n s . T h e i n (cid:12) n i t e - o r d e r V M A o f t h e o b s e r v a b l e s c a n b e 8 1 C A F o r t h e ir e s t im a t io n s t r a t e g y , G lic k a n d R o g o (cid:11) h a n d le in t h is w a y . t(cid:0) 9 T o id e n t ify d e m a n d s h o c k s , G lic k a n d R o g o (cid:11) a d d w o r ld a n d c o u n t r y - s p e c i(cid:12) c g o v e r n m e n t s p e n d in g s h o c k s o t h e ir m o d e l. A ls o , t h e y a n a ly z e t h e ir m o d e l w h e n t h e le v e l o f t h e c o u n t r y - s p e c i(cid:12) c t e c h n o lo g y s h o c k is a A t a t io n a r y (cid:12) r s t - o r d e r a u t o r e g r e s s iv e p r o c e s s . T h is in t r o d u c e s o n e la g o f (cid:1) in t o e q u a t io n ( 2 ) . C ;t 5

w ( a ( w (cid:17) a S (cid:1) (cid:12) a (cid:11) s a i s t a f a ( r t e a 2 t d s o p t p p e r i t t e n L L (cid:1) I = (cid:22) + (cid:11) ( ) (cid:17) + (cid:11) ( ) (cid:17) ; 4 ) t I I ;C C ;t I ;W W ;t n d L L (cid:1) C A = (cid:22) + (cid:11) ( ) (cid:17) + (cid:11) ( ) (cid:17) ; 5 ) t C A C A ;C C ;t C A ;W W ;t h e r e (cid:22) a n d (cid:22) a r e c o n s t a n t t e r m s , t h e l a g p o l y n o m i a l o p e r a t o r s a r e o f i n (cid:12) n i t e o r d e r , I C A i s a v e c t o r o f i n n o v a t i o n s o f c o u n t r y - s p e c i (cid:12) c s h o c k s t h a t i n c l u d e s t h e i n n o v a t i o n o f A , C ;t C ;t n d (cid:17) i s a v e c t o r o f i n n o v a t i o n s o f w o r l d s h o c k s t h a t i n c l u d e s t h e i n n o v a t i o n o f A . W ;t W ;t i n c e (cid:17) a n d (cid:17) c o n t a i n m o r e t h a n t h e i n n o v a t i o n s o f t e c h n o l o g y s h o c k s , w e a l l o w f o r C ;t W ;t I a n d (cid:1) C A t o r e s p o n d t o a d i v e r s e c o l l e c t i o n o f s h o c k s t h a t i n c l u d e s , f o r e x a m p l e , t a s t e , t t s c a l , a n d , m o n e t a r y s h o c k s . W e a s s u m e t h a t t h e i n n o v a t i o n s a r e u n c o r r e l a t e d a t a l l l e a d s n d l a g s . T h e d y n a m i c s o f t h i s b i v a r i a t e s y s t e m r e s i d e i n t h e l a g p o l y n o m i a l o p e r a t o r s L L L L ( ) ; (cid:11) ( ) ; (cid:11) ( ) , a n d (cid:11) ( ) . U s i n g t h i s s y s t e m , w e i m p o s e , o n e - b y - o n e , I ;C I ;W C A ;C C A ;W e v e r a l t h e o r e t i c a l r e s t r i c t i o n s o n t h e d y n a m i c s o f e q u a t i o n s ( 4 ) a n d ( 5 ) , b y a n a l o g y t o K i n g n d W a t s o n ( 1 9 9 5 ) . T o i m p l e m e n t t h e K i n g - W a t s o n m e t h o d , t h e o b s e r v a b l e s , I a n d C A , n e e d t o b e t t n t e g r a t e d . W e (cid:12) r s t c a l c u l a t e t h e E l l i o t , R o t h e n b e r g , a n d S t o c k ( 1 9 9 6 ) g e n e r a l i z e d l e a s t q u a r e s m o d i (cid:12) c a t i o n o f t h e D i c k e y - F u l l e r ( G L S - D F ) t (cid:0) r a t i o a n d t h e D i c k e y - F u l l e r ( D F ) (cid:0) r a t i o f r o m t h e a u g m e n t e d D F ( A D F ) r e g r e s s i o n . W e f a i l t o r e j e c t t h e u n i t r o o t n u l l t 5 p e r c e n t f o r b o t h I a n d C A . T h e O L S e s t i m a t e o f t h e a u t o r e g r e s s i v e ( A R ) r o o t t t r o m t h e A D F r e g r e s s i o n i s 0 . 8 5 f o r i n v e s t m e n t a n d 0 . 8 7 f o r C A ; t h e S t o c k ( 1 9 9 1 ) l o w e r t n d u p p e r 9 5 p e r c e n t a s y m p t o t i c c o n (cid:12) d e n c e l i m i t s o f t h e s e A R r o o t s a r e ( 0 : 7 3 ; 1 : 0 4 ) a n d 0 : 8 5 ; 1 : 0 5 ) , r e s p e c t i v e l y . G i v e n t h e w e l l k n o w n p o w e r p r o b l e m s i n h e r e n t i n t e s t s f o r u n i t o o t s a n d t h e l e n g t h o f o u r s a m p l e , i t i s n o t p o s s i b l e t o m a k e d e (cid:12) n i t i v e s t a t e m e n t s a b o u t h e s i z e o f t h e l a r g e s t A R r o o t i n o u r s e r i e s . N o n e t h e l e s s , i t i s a p p a r e n t t h a t t h e s e s e r i e s a r e x t r e m e l y p e r s i s t e n t . W e t a k e t h i s e v i d e n c e t o i m p l y t h a t t h e u n i t r o o t a s s u m p t i o n i s n o t n u n r e a s o n a b l e a p p r o x i m a t i o n . . 2 S V A R I d e n t i (cid:12) c a t i o n s U n d e r t h e a s s u m p t i o n t h a t I a n d C A a r e i n t e g r a t e d , w e c o n s t r u c t i d e n t i (cid:12) c a t i o n s o f t t h e S V A R i m p l i e d b y ( 4 ) a n d ( 5 ) . W e u s e t h e p e r m a n e n t r e s p o n s e s o f I a n d t h e C A t o t t i (cid:11) e r e n t s h o c k s t o c o n s t r u c t o n e t y p e o f i d e n t i (cid:12) c a t i o n r e s t r i c t i o n . W e i d e n t i f y t e c h n o l o g y 1 0 h o c k s a s t h e o n l y s o u r c e o f l o n g - r u n m o v e m e n t s i n I a n d C A . T h a t i s , w e a s s u m e t h a t t h e t t n l y p e r m a n e n t w o r l d d i s t u r b a n c e i s t h e w o r l d t e c h n o l o g y s h o c k , A . L i k e w i s e , t h e o n l y W ;t e r m a n e n t c o u n t r y - s p e c i (cid:12) c d i s t u r b a n c e i s t h e c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k , A . I n C ;t h i s c a s e , i n n o v a t i o n s i n A a n d A , a r e i d e n t i (cid:12) e d a s e x o g e n o u s s h o c k s w i t h ( p o t e n t i a l l y ) W ;t C ;t e r m a n e n t a (cid:11) e c t s o n I a n d C A . W e m e a s u r e t h e l o n g - r u n r e s p o n s e s o f I a n d C A t o t t t t e r m a n e n t m o v e m e n t s i n A a n d A u s i n g s u m s o f t h e l a g p o l y n o m i a l o p e r a t o r s o f t h e W ;t C ;t 1 0 I C A A lt h o u g h t h is a s s u m p t io n id e n t i(cid:12) e s t h e s o u r c e o f lo n g - r u n m o v e m e n t s in a n d , o t h e r s h o c k s m a y t t x is t , fo r e x a m p le (cid:12) s c a l s h o c k s , t h a t g e n e r a t e o b s e r v a t io n a lly e q u iv a le n t (cid:13) u c t u a t io n s in t h e s e v a r ia b le s . 6

V c t r t e t S e T j ( G o a A C c ( T ( A A l o z o ( W o c L 1 M A o f ( 4 ) a n d ( 5 ) . F o r e x a m p l e , t h e s u m o f t h e e l e m e n t s o f (cid:11) ( ) , d e n o t e d (cid:11) ( ) , I ;W I ;W a p t u r e s t h e l o n g - r u n r e s p o n s e o f I t o a o n e u n i t , p e r m a n e n t m o v e i n A . T o d i s t i n g u i s h t W ;t h e p e r m a n e n t i m p a c t o f A o n I a n d C A f r o m t h a t o f A , w e a d o p t r e s t r i c t i o n s t h a t W ;t t t C ;t e p r e s e n t d i (cid:11) e r e n t a s p e c t s o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . T o m o t i v a t e t h e (cid:12) r s t o f o u r a l t e r n a t i v e i d e n t i f y i n g r e s t r i c t i o n s , w e b e g i n b y n o t i n g h a t u n d e r t h e a s s u m p t i o n s t h a t c o u n t r i e s s h a r e t h e s a m e t e c h n o l o g y , p o s s e s s i d e n t i c a l p r e f r e n c e s , a n d h a v e s i m i l a r ( i n i t i a l ) w e a l t h p o s i t i o n s , t h e s m a l l o p e n e c o n o m y m o d e l p r e d i c t s h a t c o m m o n , w o r l d s h o c k s d o n o t m a t t e r f o r t h e c u r r e n t a c c o u n t a t a n y f o r e c a s t h o r i z o n . i n c e a l l s m a l l o p e n e c o n o m i e s r e a c t i n t h e s a m e w a y t o w o r l d s h o c k s , t h e r e a c t i o n o f e a c h c o n o m y ’ s p e r m a n e n t i n c o m e i s t h e s a m e . A s a r e s u l t , c u r r e n t a c c o u n t s r e m a i n u n c h a n g e d . L h i s i m p l i e s t h a t t h e e l e m e n t s o f t h e l a g p o l y n o m i a l o p e r a t o r (cid:11) ( ) i n e q u a t i o n ( 5 ) a r e C A ;W o i n t l y r e s t r i c t e d b y 0 1 (cid:11) = (cid:11) = : : : = (cid:11) = : : : = 0 : 6 ) C A ;W ; C A ;W ; C A ;W ;j 0 l i c k a n d R o g o (cid:11) ( 1 9 9 5 ) t e s t a n d c a n n o t r e j e c t t h e h y p o t h e s i s t h a t (cid:11) = 0 f o r a v a r i a n t C A ;W ; L f t h e V M A o f ( 4 ) a n d ( 5 ) t h a t s e t s = 0 a n d g i v e n t h e i r ( o b s e r v a b l e ) p r o x i e s f o r (cid:1) A C ;t n d (cid:1) A . W ;t W h e n w e i d e n t i f y l o n g - r u n (cid:13) u c t u a t i o n s i n I w i t h a p e r m a n e n t c h a n g e i n t h e l e v e l o f t 1 , e q u a t i o n ( 4 ) i m p l i e s i t i s m e a s u r e d b y (cid:11) ( ) (cid:17) . L i k e w i s e , t h e l o n g r u n r e s p o n s e o f W ;t I ;W W ;t 1 A t o a p e r m a n e n t c h a n g e i n t h e l e v e l o f A i s m e a s u r e d b y (cid:11) ( ) (cid:17) . T h e l o n g - r u n t W ;t C A ;W W ;t h a n g e i n C A w i t h r e s p e c t t o a p e r m a n e n t c h a n g e i n I , i s t h e n g i v e n b y t t 1 (cid:11) ( ) C A ;W L R = : 7 ) C A ;I 1 (cid:11) ( ) I ;W h e l o n g - r u n m u l t i p l i e r o f ( 7 ) a l l o w s u s t o s t u d y a n i m p l i c a t i o n o f t h e j o i n t r e s t r i c t i o n o f 6 ) . I n t h i s c a s e , e x o g e n o u s , p e r m a n e n t c h a n g e s i n t h e l e v e l o f t h e w o r l d t e c h n o l o g y s h o c k , , d o n o t m a t t e r f o r C A i n t h e l o n g r u n . T h i s i s W ;t t R 1 : L R = 0 . C A ;I n i n t e r p r e t a t i o n o f R 1 i s t h a t C A i s n e u t r a l w i t h r e s p e c t t o p e r m a n e n t m o v e m e n t s i n t h e t e v e l o f A . T h i s m a k e s R 1 p a r t o f t h e m a i n t a i n e d h y p o t h e s i s o f t h e i n t e r t e m p o r a l , s m a l l W ;t p e n e c o n o m y m o d e l . S i n c e t h e r e s t r i c t i o n s o f ( 6 ) i m p l y t h e l o n g - r u n m u l t i p l i e r o f ( 7 ) e q u a l s e r o , R 1 i s a n e c e s s a r y c o n d i t i o n f o t t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . T h e o t h e r l o n g - r u n d e r i v a t i v e w e c o n s t r u c t c a p t u r e s t h e r e s p o n s e o f I t o a p e r m a n e n t t n e u n i t c h a n g e i n C A t 1 (cid:11) ( ) I ;C : 8 ) L R = I ;C A 1 (cid:11) ( ) C A ;C h e n I i s i n d e p e n d e n t o f l o n g - r u n c h a n g e s i n t h e c o u n t r y - s p e c i (cid:12) c t e c h n o l o g y s h o c k , t h e t n l y s o u r c e o f l o n g - r u n (cid:13) u c t u a t i o n s i n I i s p e r m a n e n t c h a n g e s i n t h e l e v e l o f A . I n t h i s t W ;t a s e , t h e l o n g - r u n m o v e m e n t i n I w i t h r e s p e c t t o a p e r m a n e n t c h a n g e s i n C A i s t t 7

W t e T T ( ( a ( w ( T r i m i S ( p r h s s e o o a s R 2 : L R = 0 . I ;C A h e n w e (cid:12) n d t h a t t h e d a t a s u p p o r t s R 2 t h e i n f e r e n c e w e d r a w i s t h a t o n l y t h e w o r l d 1 1 e c h n o l o g y s h o c k , A , d r i v e s I i n t h e l o n g r u n . I m p l i c i t l y , G l i c k a n d R o g o (cid:11) i n v o k e R 2 t o W ;t t 1 2 x p l a i n t h e i r e m p i r i c a l o b s e r v a t i o n t h a t (cid:1) I r e s p o n d s b y m o r e t o A t h a n d o e s (cid:1) C A . t C ;t t h e o t h e r t y p e o f t h e o r e t i c a l r e s t r i c t i o n w e s t u d y i m p o s e s a c a u s a l o r d e r i n g o n I a n d C A . t t h i s k i n d o f i d e n t i (cid:12) c a t i o n r e q u i r e s u s t o m o v e t o t h e S V A R i m p l i e d b y t h e V M A o f e q u a t i o n s 4 ) a n d ( 5 ) : L L 0 1 1 (cid:1) I = (cid:21) (cid:1) C A + (cid:21) ( ) (cid:1) I + (cid:21) ( ) (cid:1) C A + (cid:17) ; 9 ) t I ;C A ; t I ;I t(cid:0) I ;C A t(cid:0) W ;t n d L L 0 1 1 (cid:1) C A = (cid:21) (cid:1) I + (cid:21) ( ) (cid:1) I + (cid:21) ( ) (cid:1) C A + (cid:17) ; 1 0 ) t C A ;I ; t C A ;I t(cid:0) C A ;C A t(cid:0) C ;t h e r e t h e p o l y n o m i a l l a g o p e r a t o r s a r e o f o r d e r p a n d i t i s a s s u m e d t h a t E E E + + f (cid:17) g = 0 ; f (cid:17) g = 0 ; f (cid:17) (cid:17) g = 0 ; 8 j ; s : 1 1 ) W ;t C ;t W ;t j C ;t s h e l a s t e q u a l i t y i m p l i e s t h e c o v a r i a n c e m a t r i x o f (cid:17) a n d (cid:17) i s d i a g o n a l . W ;t C ;t O n e w a y t o j u s t - i d e n t i f y t h e S V A R o f e q u a t i o n s ( 9 ) a n d ( 1 0 ) i s t o r e s t r i c t t h e i m p a c t 0 e s p o n s e o f (cid:1) I t o (cid:1) C A , d e n o t e d (cid:21) . F o r e x a m p l e , i m p o s i n g t h e r e s t r i c t i o n t t I ;C A ; 0 R 3 : (cid:21) = 0 I ;C A ; s e q u i v a l e n t t o t h e e q u i l i b r i u m s t r u c t u r e o f t h e G l i c k - R o g o (cid:11) v e r s i o n o f t h e i n t e r t e m p o r a l 1 3 o d e l i n w h i c h I i s d e t e r m i n e d p r i o r t o C A i n e q u i l i b r i u m . T h a t i s , t h i s v e r s i o n o f t h e t t n t e r t e m p o r a l m o d e l y i e l d s a n i m p a c t r e s p o n s e o f (cid:1) I t o (cid:1) C A e q u a l t o z e r o . t t O u r f o u r t h r e s t r i c t i o n e x p l o r e s a n i m p l i c a t i o n o f ( 6 ) o n t h e s h o r t - r u n d y n a m i c s o f t h e V A R o f ( 9 ) a n d ( 1 0 ) . N o t e t h a t t h e r e s t r i c t i o n s o f ( 6 ) i m p l y t h a t 0 1 (cid:21) = (cid:21) = : : : = (cid:21) = 0 : 1 2 ) C A ;I ; C A ;I ; C A ;I ;p 1 1 L R I I t s h o u ld b e n o t e d t h a t fo r t o e x is t , m u s t b e in t e g r a t e d . H o w e v e r , t h is lo n g - r u n m u lt ip lie r C A ;I t C A C A la c e s n o r e s t r ic t io n s o n t h e o r d e r o f in t e g r a t io n o f . F o r e x a m p le , w h e n is s t a t io n a r y , it c a n n o t t t L R e s p o n d t o p e r m a n e n t s h o c k s o f a n y k in d . I n t h is c a s e , e q u a ls z e r o b y d e (cid:12) n it io n . O n t h e o t h e r C A ;I I a n d , w h e n w e s t u d y t h e lo n g - r u n r e s p o n s e o f t o p e r m a n e n t c h a n g e s in t h e c o u n t r y - s p e c i(cid:12) c t e c h n o lo g y t C A h o c k , w e n e e d t o a s s u m e t h a t is in t e g r a t e d . t 1 2 A T o e x p la in t h e ir e m p ir ic a l r e s u lt s , G lic k a n d R o g o (cid:11) a r g u e t h a t fo llo w s a r a n d o m w a lk a n d t h a t a W ;t A t a t io n a r y b u t p e r s is t e n t A R p r o c e s s g e n e r a t e s . W it h in t h e c o n t e x t o f a n in t e r t e m p o r a l, s m a ll o p e n C ;t A A c o n o m y m o d e l t h a t p o s s e s s e s a b a la n c e d g r o w t h p a t h , t h e s e r e s t r ic t io n s o n a n d im p ly t h a t t h e W ;t C ;t I A n ly s o u r c e o f p e r m a n e n t m o v e m e n t s in is . t W ;t 1 3 (cid:0) C A is c o m p u t e d a s a r e s id u a l fr o m t h e a g g r e g a t e r e s o u r c e c o n s t r a in t s u b s e q u e n t t o t h e d e t e r m in a t io n t (cid:0) f in v e s t m e n t , c o n s u m p t io n , a n d o u t p u t in G lic k a n d R o g o (cid:11) ’s m o d e l. T h is r e s t r ic t io n is n o t a fe a t u r e o f I C A ll v e r s io n s o f t h e in t e r t e m p o r a l m o d e l. F o r e x a m p le , in M e n d o z a ( 1 9 9 1 , 1 9 9 3 ) , a n d a r e d e t e r m in e d t t im u lt a n e o u s ly . 8

T i t o ( a i w i w R ( c p s a c r g t b o o o a h a t i s , t h e s m a l l o p e n e c o n o m y h y p o t h e s i s t h a t C A d o e s n o t r e s p o n d t o w o r l d s h o c k s t m p l i e s t h a t (cid:1) I a n d i t s l a g s h a v e n o p r e d i c t i v e p o w e r f o r (cid:1) C A . I n s t e a d o f d i r e c t l y u s i n g t t h e r e s t r i c t i o n s o f ( 1 2 ) , w e o n l y p r e - s e t t h e i m p a c t r e s p o n s e o f (cid:1) C A t o (cid:1) I t t 0 R 4 : (cid:21) = 0 C A ;I ; n t h e S V A R . H o w e v e r , w e d o p r e s e n t s o m e d i r e c t e v i d e n c e a b o u t t h e j o i n t h y p o t h e s i s t h a t 0 0 1 2 ) e m b o d i e s . G i v e n a r e s t r i c t i o n o n e i t h e r (cid:21) ; (cid:21) ; L R o r L R , w e c o m p u t e I ;C A ; C A ;I ; I ;C A C A ;I W a l d s t a t i s t i c t o t e s t t h e h y p o t h e s i s t h a t t h e (cid:21) t e r m s a r e a l l z e r o . T h e W a l d s t a t i s t i c C A ;I ;j 2 s d i s t r i b u t e d a s y m p t o t i c a l l y (cid:31) w i t h e i t h e r p + 1 o r p d e g r e e s o f f r e e d o m d e p e n d i n g o n 0 h e t h e r (cid:21) i s e s t i m a t e d o r p r e - s e t . C A ;I ; F i n a l l y , w e a p p l y r e s t r i c t i o n s t h a t a r e a t o d d s w i t h t h e j o i n t r e s t r i c t i o n o f ( 1 2 ) . O n e s t h e i m p a c t r e s t r i c t i o n 0 R 5 : (cid:21) = (cid:0) 1 , C A ;I ; h i l e t h e o t h e r i s i t s l o n g - r u n a n a l o g u e , R 6 : L R = (cid:0) 1 . C A ;I 5 a n d R 6 r e p r e s e n t h y p o t h e s e s t h a t a r e t h e o b j e c t s o f i n t e r e s t f o r F e l d s t e i n a n d H o r i o k a 1 9 8 0 ) , S a c h s ( 1 9 8 1 ) , O b s t f e l d ( 1 9 8 6 ) , B a x t e r a n d C r u c i n i ( 1 9 9 3 ) , a n d T e s a r ( 1 9 9 1 ) . B y o m p a r i n g t h e S V A R e s t i m a t e s u n d e r t h e s e r e s t r i c t i o n s t o t h e p r e d i c t i o n s o f t h e i n t e r t e m o r a l , s m a l l o p e n e c o n o m y m o d e l t h a t a r e n o t i m p o s e d , w e o b t a i n i n f o r m a t i o n a b o u t t h e u p p o r t f o r t h e F e l d s t e i n - H o r i o k a h y p o t h e s i s . H o w e v e r , i t i s p o s s i b l e t o m a k e i n f e r e n c e s b o u t t h e d e g r e e o f i n t e r n a t i o n a l c a p i t a l m o b i l i t y u n d e r R 5 a n d R 6 o n l y w i t h a s p e c i (cid:12) c o l l e c t i o n o f r e s t r i c t i o n s p l a c e d o n t h e t y p e o f s h o c k s w i t h i n t h e m o d e l . T h u s R 5 a n d R 6 e p r e s e n t r e d u c e d f o r m i d e n t i (cid:12) c a t i o n s o f t h e S V A R o f ( 9 ) a n d ( 1 0 ) r a t h e r t h a n h a v i n g a e n e r i c s t r u c t u r a l i n t e r p r e t a t i o n w i t h i n t h e i n t e r t e m p o r a l m o d e l . T a b l e 1 c o m p a c t l y s u m m a r i z e s t h e r e s t r i c t i o n s i m p o s e d i n e a c h o f o u r s i x c a s e s , R 1 h r o u g h R 6 . ( I t w i l l b e u s e f u l t o r e f e r b a c k t o t h i s t a b l e t h r o u g h o u t t h e p a p e r . ) W e c a n r i n g t h e d i s c u s s i o n o f t h e v a r i o u s r e s t r i c t i o n s t o g e t h e r b y d e s c r i b i n g h o w w e i m p o s e R 1 (cid:0) R 6 n t h e S V A R o f e q u a t i o n s ( 9 ) a n d ( 1 0 ) . T o b e a b l e t o e s t i m a t e t h e S V A R , w e h a v e t o p r e - s e t 0 0 n e o f t h e f o u r p a r a m e t e r s (cid:21) ; (cid:21) ; L R , a n d L R . S u b s e q u e n t l y , e s t i m a t i o n I ;C A ; C A ;I ; I ;C A C A ;I 1 4 f t h e r e m a i n i n g t h r e e p a r a m e t e r s i s h a n d l e d i n a r e c u r s i v e f a s h i o n . 1 4 T h e t e c h n ic a l a p p e n d ix o f K in g a n d W a t s o n ( 1 9 9 7 ) p r o v id e s a fu lle r d e s c r ip t io n o f t h e e s t im a t io n s t r a t e g y s d o e s o u r a p p e n d ix . 9

u i s a o c d (cid:1) t T m s s o f e n 3 R L i i a (cid:0) p 0 b p m i 3 . S t r u c t u r a l V A R E s t i m a t e s T h i s s e c t i o n r e p o r t s t h e r e s u l t s o f e s t i m a t i n g t h e S V A R o f e q u a t i o n s ( 9 ) a n d ( 1 0 ) n d e r o n e o f t h e s i x a l t e r n a t i v e i d e n t i f y i n g c o n d i t i o n s . W e w o r k w i t h d a t a o n C a n a d i a n n v e s t m e n t a n d t h e c u r r e n t a c c o u n t , i n r e a l C a n a d i a n d o l l a r s . O b s e r v a t i o n s a r e q u a r t e r l y , p a n t h e p e r i o d 1 9 7 3 : 1 (cid:0) 1 9 9 5 : 4 , a n d a r e s e a s o n a l l y a d j u s t e d a t a n n u a l r a t e s . O u r e s t i m a t e s r e b a s e d o n t h e 1 9 7 5 : 1 (cid:0) 1 9 9 5 : 4 s a m p l e , w i t h d a t a p r i o r t o 1 9 7 5 : 1 u s e d a s l a g s . W e f o c u s n C a n a d a b e c a u s e i t (cid:12) t s t h e d e s c r i p t i o n o f t h e t e x t b o o k s m a l l o p e n e c o n o m y , b u t w e a l s o o n d u c t t h e a n a l y s i s o n t h e r e s t o f t h e G (cid:0) 7 . T h e s e r e s u l t s , a n d a d d i t i o n a l d e t a i l s a b o u t t h e a t a , a r e a v a i l a b l e o n r e q u e s t i n a n a p p e n d i x . O u r d a t a s e t p r o d u c e s r e d u c e d f o r m e s t i m a t e s o f t h e c o n t e m p o r a n e o u s c o r r e l a t i o n o f C A a n d (cid:1) I t h a t r e s e m b l e e s t i m a t e s r e p o r t e d e l s e w h e r e . G l i c k a n d R o g o (cid:11) ( 1 9 9 5 ) e s t i m a t e t t h e e q u a t i o n 0 1 (cid:1) C A = b + b (cid:1) I + (cid:29) : t t t h e s e a u t h o r s n o t e t h a t m u c h o f t h e l i t e r a t u r e t h a t s t u d i e s t h e d e g r e e o f i n t e r n a t i o n a l c a p i t a l o b i l i t y e x a m i n e s t h e s l o p e c o e (cid:14) c i e n t o f t h i s r e g r e s s i o n . G l i c k a n d R o g o (cid:11) r e p o r t t h a t t h e l o p e c o e (cid:14) c i e n t i s l e s s t h a n z e r o , w h i c h c a s t s d o u b t o n t h e F e l d s t e i n a n d H o r i o k a ( 1 9 8 0 ) t o r y o f i s o l a t e d c a p i t a l m a r k e t s , b u t l e s s ( i n a b s o l u t e t e r m s ) t h a n t h e v a l u e o f n e g a t i v e 1 n e t h a t s o m e a r g u e r e p r e s e n t s p e r f e c t c a p i t a l m o b i l i t y i n t e r n a t i o n a l l y . O u r e s t i m a t e o f b o r C a n a d a i s (cid:0) 0 : 3 8 , w i t h a s t a n d a r d e r r o r o f 0 : 0 8 . G l i c k a n d R o g o (cid:11) r e p o r t a n a n a l o g o u s s t i m a t e o f (cid:0) 0 : 3 0 w i t h a s t a n d a r d e r r o r o f 0 : 1 0 . O f c o u r s e , w i t h o u t a n i d e n t i (cid:12) c a t i o n s c h e m e , o s t r u c t u r a l i n t e r p r e t a t i o n c a n b e g i v e n t o t h e s e e s t i m a t e s . . 1 Z e r o L o n g R u n M u l t i p l i e r R e s t r i c t i o n s : R 1 a n d R 2 I n t h e (cid:12) r s t t w o r o w s o f t a b l e 2 , w e p r e s e n t e s t i m a t e s c o n d i t i o n a l o n t h e r e s t r i c t i o n s 0 0 1 a n d R 2 , r e s p e c t i v e l y . T h e (cid:12) r s t f o u r c o l u m n s d i s p l a y t h e e s t i m a t e s o f (cid:21) , (cid:21) , I ;C A ; C A ;I ; R , a n d L R , r e s p e c t i v e l y . R e c a l l f r o m t a b l e 1 t h a t u n d e r R 1 , C A i s b y c o n s t r u c t i o n I ;C A C A ;I t n d e p e n d e n t o f p e r m a n e n t c h a n g e s i n A . A s s e e n f r o m t h e (cid:12) r s t c e l l o f t a b l e 2 , t h e e s t i m a t e d W ;t 0 m p a c t r e s p o n s e o f (cid:1) I t o (cid:1) C A , (cid:21) , i s (cid:0) 0 : 5 6 , w i t h a t (cid:0) r a t i o g r e a t e r t h a n t w o ( i n t t I ;C A ; b s o l u t e v a l u e ) . T h e e s t i m a t e o f L R i s n e g a t i v e a s w e l l b u t w i t h a t (cid:0) r a t i o o f o n l y I ;C A 0 1 : 3 6 . T h e e s t i m a t e o f (cid:21) i s i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o , s u g g e s t i n g a l a c k o f C A ;I ; r e d i c t i v e p o w e r o f (cid:1) I f o r (cid:1) C A . t t T h e W a l d s t a t i s t i c s i n t h e (cid:12) n a l c o l u m n a r e c o m p u t e d f o r t h e j o i n t h y p o t h e s i s (cid:21) = C A ;I ;j ; j = 0 ; : : : ; 4 , g i v e n R 1 . T h e t e s t s t a t i s t i c o f 9 . 0 9 i n d i c a t e s t h a t t h e n u l l h y p o t h e s i s c a n e r e j e c t e d , b u t o n l y a t t h e 1 1 p e r c e n t l e v e l o f s i g n i (cid:12) c a n c e . A t e i t h e r t h e 5 p e r c e n t o r 1 0 e r c e n t l e v e l s , (cid:1) I a n d i t s l a g s a r e u n i m p o r t a n t f o r (cid:1) C A , u n d e r R 1 , w h i c h s u p p o r t s t h e t t o d e l ’ s p r e d i c t i o n t h a t w o r l d s h o c k s d o n o t m a t t e r f o r m o v e m e n t s i n C A . t T h e s e c o n d r o w d i s p l a y s e s t i m a t e s u n d e r t h e r e s t r i c t i o n R 2 : L R = 0 . T h i s I ;C A d e n t i (cid:12) e s (cid:13) u c t u a t i o n s i n I e x c l u s i v e l y w i t h p e r m a n e n t c h a n g e s i n A . T h e (cid:12) r s t o f t h e s e t W ;t 1 0

e m (cid:0) i t w 3 g I ( f t i R (cid:13) R (cid:21) o t (cid:21) T (cid:1) r i 1 w c h 3 i (cid:0) e f 0 s t i m a t e s , (cid:21) , i s i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o , s u g g e s t i n g t h a t i n v e s t m e n t i s d e t e r - I ;C A ; 0 i n e d p r i o r t o t h e c u r r e n t a c c o u n t i n t h e s h o r t r u n . T h e e s t i m a t e o f (cid:21) i s n e g a t i v e , a t C A ;I ; 0 : 3 0 w i t h a s t a n d a r d e r r o r o f 0 : 1 7 . T h e e s t i m a t e o f L R i s a l s o n e g a t i v e , b u t i n s i g n i f - C A ;I c a n t . T h e W a l d s t a t i s t i c i n t h e (cid:12) n a l c o l u m n i n d i c a t e s a r e j e c t i o n o f t h e j o i n t h y p o t h e s i s h a t (cid:21) = 0 ; j = 0 ; : : : ; 4 , a t b e t t e r t h a n t h e (cid:12) v e p e r c e n t l e v e l . T h i s i m p l i e s t h a t C A ;I ;j o r l d s h o c k s d o a (cid:11) e c t t h e c u r r e n t a c c o u n t . . 2 Z e r o I m p a c t R e s t r i c t i o n s : R 3 a n d R 4 T h e t h i r d r o w o f t a b l e 2 c o n t a i n s t h e r e s u l t s o f e s t i m a t i n g e q u a t i o n s ( 9 ) a n d ( 1 0 ) 0 i v e n R 3 , (cid:21) = 0 . T h i s i d e n t i f y i n g r e s t r i c t i o n i m p l i e s t h a t I i s d e t e r m i n e d p r i o r t o C A . I ;C A ; t t 0 n a d d i t i o n , R 3 i s o n e o f s e v e r a l a s s u m p t i o n s n e c e s s a r y t o i n t e r p r e t (cid:21) a s a m e a s u r e o f C A ;I ; s h o r t - r u n ) i n t e r n a t i o n a l c a p i t a l m o b i l i t y w i t h i n t h e i n t e r t e m p o r a l m o d e l . 0 1 T h e e s t i m a t e o f (cid:21) , (cid:0) 0 : 3 6 , i s q u i t e c l o s e t o t h e e s t i m a t e o f b f r o m t h e r e d u c e d - C A ;I ; o r m r e g r e s s i o n r e p o r t e d a b o v e . T h e e s t i m a t e p o s s e s s e s a t (cid:0) r a t i o o f (cid:0) 4 : 5 . T h i s r e s u l t e c h o e s h o s e o f o t h e r r e s e a r c h e r s , a s w e n o t e i n t h e I n t r o d u c t i o n . E s t i m a t e s o f L R p r o v i d e I ;C A n f o r m a t i o n a b o u t t h e l o n g - r u n e (cid:11) e c t o f a p e r m a n e n t c h a n g e i n A o n I , c o n d i t i o n a l o n C ;t t 3 . S i n c e t h e e s t i m a t e i s i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o , i t s u g g e s t s t h a t p e r m a n e n t u c t u a t i o n s i n i n v e s t m e n t d o n o t d e p e n d o n t h e l e v e l o f A . T h e e s t i m a t e o f L R u n d e r C ;t C A ;I 3 i s (cid:0) 0 : 2 6 w i t h a s t a n d a r d e r r o r o f 0 : 1 2 . T h e W a l d s t a t i s t i c i n d i c a t e s t h a t t h e h y p o t h e s i s = 0 ; 8 j = 0 ; : : : ; 4 , i s s t r o n g l y r e j e c t e d . T h i s r e j e c t i o n r e (cid:13) e c t s t h e l a r g e t (cid:0) r a t i o C A ;I ;j 0 n (cid:21) u n d e r R 3 . C A ;I ; 0 T h e n e x t r o w r e p o r t s t h e r e s u l t s u n d e r R 4 , (cid:21) = 0 . T h e r e s u l t s a r e v e r y s i m i l a r C A ;I ; o t h o s e u n d e r R 1 d i s c u s s e d a b o v e : L R i s i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o , w h i l e C A ;I 0 a n d L R a r e n e g a t i v e w i t h t (cid:0) r a t i o s n e a r o r g r e a t e r t h a n t w o i n a b s o l u t e t e r m s . I ;C A ; I ;C A 0 h e e s t i m a t e s o f (cid:21) a n d L R a r e (cid:0) 0 : 5 4 a n d (cid:0) 0 : 6 4 , r e s p e c t i v e l y . S i n c e (cid:13) u c t u a t i o n s i n I ;C A ; I ;C A C A d r i v e (cid:1) I , i t s u g g e s t s t h a t t h e c u r r e n t a c c o u n t i s c a u s a l l y p r i o r t o i n v e s t m e n t . T h e s e t t e s u l t s a l s o i m p l y t h a t l a r g e r c u r r e n t a c c o u n t d e (cid:12) c i t s h a v e t h e e (cid:11) e c t o f i n c r e a s i n g i n v e s t m e n t n t h e l o n g r u n . F i n a l l y , t h e W a l d s t a t i s t i c u s e d t o t e s t t h e h y p o t h e s i s (cid:21) = 0 ; j = C A ;I ;j ; : : : ; 4 i n d i c a t e s a b o r d e r l i n e r e j e c t i o n , j u s t a s u n d e r R 1 ( t h e p - v a l u e i s 0 . 1 5 ) . H o w e v e r , e c a n n o t r e j e c t a t (cid:12) v e p e r c e n t t h e h y p o t h e s i s t h a t C A d o e s n o t d e p e n d o n p e r m a n e n t t h a n g e s i n t h e w o r l d s h o c k . T h u s , a c r o s s t h e i d e n t i (cid:12) c a t i o n s R 1 - R 4 , r e j e c t i o n o f t h e n u l l y p o t h e s i s o f ( 1 2 ) a r e f a i r l y c o m m o n ; i n d e e d , a l l r e j e c t a t t h e (cid:12) f t e e n p e r c e n t l e v e l . . 3 R e d u c e d F o r m R e s t r i c t i o n s : R 5 a n d R 6 P e r h a p s t h e m o s t s t u d i e d a s p e c t o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l i s 0 0 t s a s s u m p t i o n o f p e r f e c t c a p i t a l m o b i l i t y . A l t h o u g h R 5 , (cid:21) = (cid:0) 1 , a n d R 6 , L R = C A ;I ; C A ;I ; 1 , r e p r e s e n t o n l y r e d u c e d f o r m i d e n t i (cid:12) c a t i o n s , t h e y p r o v i d e u s w i t h u s e f u l i n f o r m a t i o n t o v a l u a t e t h e c l a i m s o f F e l d s t e i n a n d H o r i o k a ( 1 9 8 0 ) , S a c h s ( 1 9 8 1 ) , a n d o t h e r s . T h e r e s u l t s u n d e r R 5 a p p e a r i n t h e (cid:12) f t h r o w o f t a b l e 2 . T h e m o s t n o t a b l e d i (cid:11) e r e n c e s 0 r o m i m p o s i n g t h i s r e s t r i c t i o n a p p e a r i n t h e e s t i m a t e s o f (cid:21) a n d L R . U n d e r R 5 , I ;C A ; C A ;I 1 1

(cid:21) b p i n T t t n t n d t (cid:21) T m i m t t t 3 m T r i o R i m R s w e p W 0 i s p o s i t i v e w i t h a t (cid:0) r a t i o g r e a t e r t h a n t w o . T h i s e s t i m a t e i m p l i e s t h a t (cid:1) I r i s e s I ;C A ; t y o v e r t w o u n i t s g i v e n a o n e u n i t i n c r e a s e i n (cid:1) C A . T h e e s t i m a t e o f L R i s a l s o t I ;C A o s i t i v e , a l t h o u g h w i t h a t (cid:0) r a t i o o n l y s l i g h t l y l a r g e r t h a n 1 : 0 . T h e f a c t t h a t t h i s e s t i m a t e s i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o s u g g e s t s t h a t p e r m a n e n t , c o u n t r y - s p e c i (cid:12) c s h o c k s h a v e o e (cid:11) e c t o n i n v e s t m e n t , s o t h a t I d e p e n d s o n l y o n p e r m a n e n t c h a n g e s i n t h e l e v e l o f A . t W ;t h e e s t i m a t e o f L R i s n e g a t i v e a n d h a s a t w o s t a n d a r d d e v i a t i o n c o n (cid:12) d e n c e i n t e r v a l C A ;I h a t d o e s n o t i n c l u d e z e r o , b u t d o e s i n c l u d e n e g a t i v e o n e . T h e W a l d s t a t i s t i c u s e d t o t e s t h e h y p o t h e s i s (cid:21) = 0 ; j = 1 ; : : : ; 4 i s 0 . 9 0 , i m p l y i n g t h a t w e c a n n o t r e j e c t t h e C A ;I ;j u l l h y p o t h e s i s a t a n y r e a s o n a b l e s i g n i (cid:12) c a n c e l e v e l . T h i s i s a m a r k e d r e v e r s a l f r o m t h e W a l d e s t s u n d e r R 1 - R 4 , w h e r e t h e r e w e r e e i t h e r s t r o n g r e j e c t i o n s o r b o r d e r l i n e r e j e c t i o n s o f t h e u l l . 0 0 I n t h e (cid:12) n a l r o w o f t a b l e 2 , w e d i s p l a y e s t i m a t e s o f (cid:21) ; (cid:21) a n d L R c o n - I ;C A ; C A ;I ; I ;C A i t i o n a l o n t h e r e d u c e d f o r m - l o n g r u n i d e n t i (cid:12) c a t i o n R 6 . T h e p o i n t e s t i m a t e s a r e s i m i l a r 0 o t h o s e u n d e r R 5 : (cid:21) a n d L R a r e p o s i t i v e b u t i n s i g n i (cid:12) c a n t i n t h i s i n s t a n c e , w h i l e I ;C A ; I ;C A 0 i s n e g a t i v e , s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m z e r o , a n d i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m (cid:0) 1 . C A ;I ; 0 0 o g e t h e r , t h e s e e s t i m a t e s o f (cid:21) , (cid:21) , a n d L R s u g g e s t t h a t i n v e s t m e n t i s d e t e r - I ;C A ; C A ;I ; I ;C A i n e d p r i o r t o t h e c u r r e n t a c c o u n t , t h a t t h e r e s p o n s e o f C A t o I i s a b o u t n e g a t i v e o n e t t n t h e s h o r t r u n ( w h i c h i s i m p o s e d u n d e r R 5 ) , a n d t h a t (cid:1) I d e p e n d s o n l y o n p e r m a n e n t t o v e m e n t s i n A . A s d i s c u s s e d a b o v e , t h e s e r e s u l t s a r e a l l c o n s i s t e n t w i t h p r e d i c t i o n s o f W ;t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . I n a d d i t i o n , t h e W a l d t e s t i n d i c a t e s a f a i l u r e o r e j e c t t h e j o i n t h y p o t h e s i s (cid:21) = 0 ; j = 0 ; : : : ; 4 . T h u s , u n d e r t h e r e s t r i c t i o n R 6 , C A ;I ;j h e C a n a d i a n d a t a a p p e a r t o s a t i s f y m a n y p r e d i c t i o n s o f t h e i n t e r t e m p o r a l m o d e l . . 4 S o m e G r a p h i c a l E v i d e n c e T h e r e s u l t s i n t a b l e 2 p r o v i d e s o m e s u p p o r t f o r t h e r e s t r i c t i o n s t h a t m a k e o n l y p e r a n e n t m o v e m e n t s i n A m a t t e r f o r I a n d t h a t p l a c e t h e d e t e r m i n a t i o n o f I p r i o r t o C A . W ;t t t t h a t i s , o u r r e s u l t s s u p p o r t R 2 a n d R 3 . O n t h e o t h e r h a n d , o u r r e s u l t s p r o v i d e e v i d e n c e t o e j e c t t h e i d e n t i (cid:12) c a t i o n s o f R 4 a n d R 5 . A t t h e s a m e t i m e , t h e e v i d e n c e o n R 1 ( L R = 0 ) a n d R 6 ( L R = (cid:0) 1 ) C A ;I C A ;I s m i x e d . A l t h o u g h w e o b t a i n e s t i m a t e s o f L R i n s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m n e g a t i v e C A ;I n e u n d e r R 5 , t h e h y p o t h e s i s L R = 0 ( a s i m p l i e d b y R 1 ) c a n n o t b e r e j e c t e d u n d e r C A ;I 2 a n d R 4 . T h e l a t t e r r e s u l t l e n d s s u p p o r t t o t h e p r e d i c t i o n t h a t p e r m a n e n t m o v e m e n t s n A d o n o t m a t t e r f o r C A . H o w e v e r , t h o s e e s t i m a t e s p r o v i d e g r e a t e r s u p p o r t f o r t h e W ;t t o d e l u n d e r R 6 ( w h i c h w e h a v e a r g u e d p o s s e s s e s n o s t r u c t u r a l i n t e r p r e t a t i o n ) t h a n u n d e r 1 . T h i s m i x e d e v i d e n c e q u e s t i o n s t h e r o b u s t n e s s o f t h e e s t i m a t e d S V A R w h e n L R C A ;I e r v e s a s t h e s o u r c e o f i d e n t i (cid:12) c a t i o n . I n o r d e r t o o b t a i n a d d i t i o n a l i n f o r m a t i o n o n t h e p l a u s i b i l i t y o f R 1 v e r s u s R 6 , w e a s k 0 0 h e t h e r t h e r e e x i s t o t h e r i d e n t i (cid:12) c a t i o n s b u i l t o n e i t h e r (cid:21) ; (cid:21) o r L R t h a t y i e l d I ;C A ; C A ;I ; I ;C A s t i m a t e s o f L R s i g n i (cid:12) c a n t l y d i (cid:11) e r e n t f r o m e i t h e r z e r o o r n e g a t i v e o n e . T h i s a p p r o a c h C A ;I r o d u c e s i n f o r m a t i o n t h a t a l l o w s u s t o e v a l u a t e t h e c o m p e t i n g h y p o t h e s e s o f R 1 a n d R 6 . 0 e b u i l d t h e s e a l t e r n a t i v e i d e n t i (cid:12) c a t i o n s o n t h e c l o s e d i n t e r v a l [ (cid:0) 1 ; 1 ] f o r e i t h e r (cid:21) o r I ;C A ; 1 2

L (cid:12) a (cid:21) a (cid:21) a u c p a o w t s r w p t t i h t o R t t d t I r a t 0 R a n d t h e c l o s e d i n t e r v a l [ (cid:0) 1 ; 0 ] f o r (cid:21) r u n n i n g i n i n c r e m e n t s o f 0 : 0 5 . I ;C A C A ;I ; T h e g r a p h i c a l e v i d e n c e a p p e a r s i n (cid:12) g u r e 1 . T h e t o p r o w a n d l o w e r l e f t p a n e l o f t h e 0 0 g u r e c o n t a i n t h e 9 5 p e r c e n t c o n (cid:12) d e n c e i n t e r v a l o f L R w i t h r e s p e c t t o (cid:21) ; (cid:21) , C A ;I I ;C A ; C A ;I ; 0 n d L R . T h e l o w e r r i g h t p a n e l d i s p l a y s t h e 9 5 p e r c e n t c o n (cid:12) d e n c e e l l i p s e o f (cid:21) a n d I ;C A I ;C A ; 0 u n d e r R 6 ( i : e . , g i v e n L R = (cid:0) 1 ) . C A ;I ; C A ;I 0 F i r s t , c o n s i d e r t h e 9 5 p e r c e n t c o n (cid:12) d e n c e i n t e r v a l o f L R g i v e n (cid:21) , w h i c h C A ;I I ;C A ; p p e a r s i n t h e t o p l e f t p a n e l o f (cid:12) g u r e 1 . T h e c o n (cid:12) d e n c e i n t e r v a l a l w a y s i n c l u d e s z e r o a s 0 0 m o v e s f r o m n e g a t i v e o n e t o w a r d z e r o . H o w e v e r , a s (cid:21) b e g i n s t o a p p r o a c h z e r o I ;C A ; I ;C A ; n d t h e n t u r n s p o s i t i v e , L R b e c o m e s s i g n i (cid:12) c a n t l y l e s s t h a n z e r o , t h e r e b y r e j e c t i n g R 1 C A ;I 0 0 n d e r t h o s e v a l u e s o f (cid:21) . H o w e v e r , e v e n a s w e p u s h (cid:21) t o w a r d o n e , t h e 9 5 p e r c e n t I ;C A ; I ;C A ; o n (cid:12) d e n c e i n t e r v a l n e v e r i n c l u d e s n e g a t i v e o n e , a s w o u l d b e i m p l i e d b y R 6 . H e n c e , t h i s p l o t r o v i d e s e v i d e n c e t h a t c a n b o t h s u p p o r t a n d r e j e c t R 1 , b u t n o e v i d e n c e t o s u p p o r t R 6 . E v i d e n c e i s s i m i l a r l y m i x e d i n t h e c o n (cid:12) d e n c e i n t e r v a l s d i s p l a y e d i n t h e u p p e r r i g h t n d l o w e r l e f t p a n e l s o f (cid:12) g u r e 1 . I n t h e u p p e r r i g h t p a n e l , t h e 9 5 p e r c e n t c o n (cid:12) d e n c e i n t e r v a l 0 0 f L R g i v e n (cid:21) i n c l u d e s b o t h z e r o , w h e n (cid:21) i s n e a r z e r o , a n d n e g a t i v e o n e , C A ;I C A ;I ; C A ;I ; 0 h e n w e p r e - s e t (cid:21) t o b e n e g a t i v e ( b e g i n n i n g a t a r o u n d (cid:0) 0 : 8 7 ) . T h u s , d e p e n d i n g o n C A ;I ; 0 h e p r e - s e t r a n g e o f v a l u e s o f (cid:21) t h e r e e x i s t s i d e n t i (cid:12) c a t i o n s t h a t g e n e r a t e e v i d e n c e t o C A ;I ; 0 u p p o r t e i t h e r R 1 o r R 6 . W e e x a m i n e t h e l i n k b e t w e e n p r e - s e t v a l u e s o f (cid:21) a n d t h e C A ;I ; e s u l t i n g e s t i m a t e o f L R a n a l y t i c a l l y i n t h e n e x t s u b - s e c t i o n . C A ;I E x a m i n i n g t h e l o w e r l e f t h a n d p a n e l , s u p p o r t f o r R 1 a p p e a r s f o r a n y v a l u e o f L R I ;C A e p r e - s e l e c t . A t t h e s a m e t i m e , t h e r e a r e n o v a l u e s o f L R i n t h e r a n g e w e c o n s i d e r t h a t I ;C A r o v i d e s u p p o r t f o r R 6 a n d a t t h e s a m e t i m e r e j e c t R 1 . I n s u m m a r y , t h e 9 5 p e r c e n t c o n (cid:12) d e n c e i n t e r v a l s o f L R m a k e c l e a r t h a t t h e i d e n - C A ;I i (cid:12) c a t i o n m a t t e r s f o r i n f e r e n c e a b o u t h y p o t h e s e s t e s t s o f R 1 a n d R 6 . W e c a n c h o o s e i d e n - 0 i (cid:12) c a t i o n s u s i n g e i t h e r (cid:21) o r L R t o g e n e r a t e c o n (cid:12) d e n c e i n t e r v a l s f o r L R t h a t I ;C A ; I ;C A C A ;I n c l u d e z e r o . A l t h o u g h t h e r e e x i s t o t h e r i d e n t i (cid:12) c a t i o n s u s i n g t h e s e p a r a m e t e r s i n w h i c h t h e y p o t h e s i s L R = 0 i s r e j e c t e d , t h e s e i d e n t i (cid:12) c a t i o n s r e q u i r e i m p l a u s i b l e v a l u e s f o r e i - C A ;I 0 h e r (cid:21) o r L R ; f o r e x a m p l e p o s i t i v e v a l u e s f o r t h e s e p a r a m e t e r s a r e o f t e n r e q u i r e d i n I ;C A ; I ;C A r d e r t o r e j e c t t h e h y p o t h e s i s o f R 1 . O n t h e o t h e r h a n d , w e r a r e l y (cid:12) n d e v i d e n c e t o s u s t a i n 0 6 . T h e o n l y w a y t o i d e n t i f y t h i s S V A R a n d n o t r e j e c t R 6 s e t s (cid:21) c l o s e t o , i f n o t e q u a l C A ;I ; 0 o , n e g a t i v e o n e . O n t h e o t h e r h a n d , w h e n t h e i d e n t i (cid:12) c a t i o n s e l e c t s a v a l u e o f (cid:21) c l o s e C A ;I ; o z e r o , t h e 9 5 p e r c e n t c o n (cid:12) d e n c e i n t e r v a l o f L R c o n t a i n s s u p p o r t f o r R 1 . C A ;I F i n a l l y , t h e 9 5 p e r c e n t c o n (cid:12) d e n c e e l l i p s e i n t h e l o w e r r i g h t h a n d p a n e l o f (cid:12) g u r e 1 0 0 i s p l a y s t h e j o i n t d i s t r i b u t i o n o f (cid:21) a n d (cid:21) g i v e n L R = (cid:0) 1 . W e u s e t h i s t o I ;C A ; C A ;I ; C A ;I 0 0 e s t t h e j o i n t h y p o t h e s i s (cid:21) = 0 a n d (cid:21) = (cid:0) 1 . T h e j o i n t h y p o t h e s i s m a k e s I ;C A ; C A ;I ; c a u s a l l y p r i o r t o C A a n d c o n t a i n s t h e r e d u c e d f o r m - s h o r t r u n r e s t r i c t i o n R 5 , g i v e n t h e t t e d u c e d f o r m - l o n g r u n i d e n t i (cid:12) c a t i o n R 6 ( a s i m p l i e d b y t h e i n t e r t e m p o r a l m o d e l ) . T h e e l l i p s e a p p e a r s l a r g e . T h i s r e (cid:13) e c t s t h e s i z e a n d s t a n d a r d e r r o r s o f t h e e s t i m a t e s 0 0 s w e l l a s t h e l a r g e n e g a t i v e c o r r e l a t i o n b e t w e e n (cid:21) a n d (cid:21) u n d e r R 6 . A l t h o u g h I ;C A ; C A ;I ; 0 h e e l l i p s e s h o w s t h a t i t i s n o t p o s s i b l e t o r e j e c t t h e j o i n t h y p o t h e s i s (cid:21) = 0 a n d I ;C A ; 1 3

(cid:21) (cid:21) t s e a t o (cid:21) L p p 3 c R t m t i o [ (cid:17) f (cid:21) C m a n y 0 0 = (cid:0) 1 , i t a l s o i n d i c a t e s t h a t t h e r e a r e o t h e r c o m b i n a t i o n s o f (cid:21) a n d C A ;I ; I ;C A ; 0 t h a t a r e e q u a l l y v a l i d . T h e 9 5 p e r c e n t c o n (cid:12) d e n c e e l l i p s e t h u s d i s p l a y s t h e e x t e n t o f C A ;I ; h e u n c e r t a i n t y t h a t e x i s t s u n d e r t h e i d e n t i (cid:12) c a t i o n R 6 a n d m a k e s i t n e x t t o i m p o s s i b l e t o 0 0 e l e c t b e t w e e n d i (cid:11) e r e n t c o m b i n a t i o n s o f (cid:21) a n d (cid:21) . I ;C A ; C A ;I ; F i g u r e 2 e x t e n d s t h e a n a l y s i s o f t h e p r e v i o u s p l o t , b y d e p i c t i n g 9 5 p e r c e n t c o n (cid:12) d e n c e 0 0 l l i p s e s o f (cid:21) a n d (cid:21) u n d e r f o u r d i (cid:11) e r e n t p r e - s e t v a l u e s o f L R : 0 : 0 0 ; (cid:0) 0 : 2 5 ; (cid:0) 0 : 5 , I ;C A ; C A ;I ; C A ;I n d (cid:0) 0 : 7 5 . O n c e a g a i n , w e a r e i n t e r e s t e d i n s e e i n g i f t h e s e e l l i p s e s c o n t a i n t h e c o m b i n a - 0 0 i o n (cid:21) = 0 a n d (cid:21) = (cid:0) 1 . T w o r e s u l t s a r e c l e a r . F i r s t , a s t h e p r e - s e t v a l u e I ;C A ; C A ;I ; f L R g o e s t o w a r d z e r o , t h e s i z e o f t h e e l l i p s e d e c r e a s e s . S e c o n d , t h e c o m b i n a t i o n o f C A ;I 0 0 = 0 a n d (cid:21) = (cid:0) 1 n o l o n g e r a p p e a r s w i t h i n t h e 9 5 p e r c e n t c o n (cid:12) d e n c e e l l i p s e a s I ;C A ; C A ;I ; R b e c o m e s l e s s n e g a t i v e t h a n (cid:0) 0 : 7 5 . T h e r e s u l t s s h o w q u i t e v i v i d l y o n e o f t h e m a i n C A ;I o i n t s o f t h e p a p e r : t h a t s u p p o r t f o r t h e i n t e r t e m p o r a l m o d e l i s s e n s i t i v e t o s e e m i n g l y s m a l l e r t u r b a t i o n s i n t h e i d e n t i (cid:12) c a t i o n . L R L R (cid:21) ; (cid:21) . 5 H o w D o , a n d A (cid:11) e c t E s t i m a t e s o f ? I ;C A ; C A ;I ; I ;C A C A ;I 0 0 F r o m t h e d i s c u s s i o n a b o v e , i t a p p e a r s d i (cid:14) c u l t t o d e c i d e o n t h e m e r i t s o f a n i d e n t i (cid:12) a t i o n t h a t s e t s L R e q u a l t o , s a y , e i t h e r (cid:0) 0 : 8 5 , n e g a t i v e o n e ( a s w o u l d b e s u g g e s t e d b y C A ;I 6 ) , o r z e r o ( a s w o u l d b e s u g g e s t e d b y R 1 ) . N o n e t h e l e s s , w e c a n p r o v i d e a n a l y s i s t h a t h e l p s o e x p l a i n w h y t h i s d i (cid:14) c u l t y e x i s t s . F o l l o w i n g K i n g a n d W a t s o n ( 1 9 9 4 ) , w e d e r i v e t h e a n a l y t i c a l r e s p o n s e o f I t o a p e r - t a n e n t m o v e m e n t i n C A a n d o f C A t o a p e r m a n e n t m o v e m e n t i n I . T o b e g i n , n o t e t h a t t t t h e r e d u c e d - f o r m V A R ( 4 ) L L (cid:1) (cid:1) (cid:1) (cid:1) 1 (cid:1) I A ( ) A ( ) I " t I ; I I ; C A t(cid:0) I ;t = + ; 2 3 2 3 2 3 2 3 L L (cid:1) (cid:1) (cid:1) (cid:1) 1 (cid:1) C A A ( ) A ( ) C A " t C A ; I C A ; C A t(cid:0) C A ;t 6 7 6 7 6 7 6 7 4 5 4 5 4 5 4 5 m p l i e s t h a t 1 (cid:0) (cid:1) 0 " (cid:17) 1 (cid:0) (cid:21) I ;t W ;t I ;C A ; = ; 2 2 3 2 3 3 (cid:1) 0 " (cid:17) (cid:0) (cid:21) 1 C A ;t C ;t C A ;I ; 6 7 6 7 6 7 4 4 5 4 5 5 1 (cid:0) (cid:1) 0 0 0 (cid:1) r e q u a t i o n - b y - e q u a t i o n " = [ 1 (cid:0) (cid:21) (cid:21) ] [ (cid:17) + (cid:21) (cid:17) ] a n d " = I ;t I ;C A ; C A ;I ; W ;t I ;C A ; C ;t C A ;t 1 (cid:0) 0 0 0 1 (cid:0) (cid:21) (cid:21) ] [ (cid:21) (cid:17) + (cid:17) ] . T h e f o r m e r e x p r e s s i o n r e v e a l s t h a t m o v e m e n t s i n I ;C A ; C A ;I ; C A ;I ; W ;t C ;t 0 b e c o m e l e s s i m p o r t a n t f o r (cid:13) u c t u a t i o n s i n (cid:1) I a s (cid:21) g o e s t o w a r d z e r o . I n s y m m e t r i c C ;t t I ;C A ; (cid:1) a s h i o n , t h e e x p r e s s i o n f o r " s h o w s t h a t (cid:13) u c t u a t i o n s i n (cid:17) m a t t e r m o r e f o r (cid:1) C A a s C A ;t W ;t t 0 m o v e s f r o m z e r o t o w a r d n e g a t i v e o n e . N e x t , c o n s t r u c t t h e l o n g - r u n t r e n d s o f I a n d C A ;I ; t A t 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) (cid:1) L R = [ 1 (cid:0) A ( ) ] [ A ( ) L R + " ] ; I ;t I ; I I ; C A C A ;t I ;t 1 4

a S i ( a ( T S w o i t L d L t ( w L i z n I [ i i t n d 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) (cid:1) L R = [ 1 (cid:0) A ( ) ] [ A ( ) L R + " ] : C A ;t C A ; C A C A ; I I ;t C A ;t (cid:1) (cid:1) u b s t i t u t i n g " a n d " f r o m a b o v e i n t o t h e s e e x p r e s s i o n s , a n d d o i n g a b i t o f a l g e b r a , I ;t C A ;t t i s s t r a i g h t f o r w a r d t o s h o w 1 1 0 (cid:1) (cid:1) (cid:1) (cid:1) + (cid:21) [ 1 (cid:0) A ( ) ] + A ( ) @ L R = @ (cid:17) I ;C A ; C A ; C A I ; C A I ;t j C ;t = ; 1 3 ) 1 1 + 0 (cid:1) (cid:1) (cid:1) (cid:1) @ L R = @ (cid:17) (cid:21) A ( ) + [ 1 (cid:0) A ( ) ] C A ;t j C ;t I ;C A ; C A ; I I ; I n d 1 1 + 0 (cid:1) (cid:1) (cid:1) (cid:1) @ L R = @ (cid:17) (cid:21) [ 1 (cid:0) A ( ) ] + A ( ) C A ;t j W ;t C A ;I ; I ; I C A ; I = : 1 4 ) 1 1 + 0 (cid:1) (cid:1) (cid:1) (cid:1) @ L R = @ (cid:17) (cid:21) A ( ) + [ 1 (cid:0) A ( ) ] I ;t j W ;t C A ;I ; I ; C A C A ; C A h e l o n g - r u n d e r i v a t i v e s ( 1 3 ) a n d ( 1 4 ) a r e e q u i v a l e n t t o L R a n d L R , r e s p e c t i v e l y . I ;C A C A ;I + + i n c e l i m @ X = @ (cid:17) = @ L R = @ (cid:17) a n d l i m @ X = @ (cid:17) = @ L R = @ (cid:17) , j ! 1 t j W ;t X ;t W ;t j ! 1 t j C ;t X ;t C ;t h e r e X = I ; C A , w e c a n e q u a t e t h e l e f t h a n d s i d e s o f ( 1 3 ) a n d ( 1 4 ) w i t h t h e r e s p o n s e t t t f I t o a p e r m a n e n t m o v e m e n t i n C A a n d t o t h e r e s p o n s e o f C A t o a p e r m a n e n t m o v e m e n t t t t n I , r e s p e c t i v e l y . t W e u s e t h e d e r i v a t i v e s ( 1 3 ) a n d ( 1 4 ) t o s t u d y t h e e (cid:11) e c t o f t h e d i (cid:11) e r e n t i d e n t i (cid:12) c a i o n s c h e m e s o n e s t i m a t e s o f L R . F i r s t , c o n s i d e r i m p o s i n g R 3 o n ( 1 3 ) w h i c h y i e l d s C A ;I 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) R ( R 3 ) = [ 1 (cid:0) A ( ) ] A ( ) . S e c o n d , e v a l u a t e ( 1 4 ) a t R 4 t o p r o - I ;C A I ; I I ; C A 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) u c e L R ( R 4 ) = [ 1 (cid:0) A ( ) ] A ( ) . T h e s e l o n g - r u n m u l t i p l i e r s , C A ;I C A ; C A C A ; I R ( R 3 ) a n d L R ( R 4 ) , t o g e t h e r w i t h a b i t o f a l g e b r a , a l l o w s u s t o w r i t e t h e d e r i v a - I ;C A ;I C A ;I i v e o f ( 1 4 ) a s 1 (cid:0) 1 1 0 (cid:1) (cid:1) (cid:1) (cid:1) (cid:21) + L R ( R 4 ) [ 1 (cid:0) A ( ) ] [ 1 (cid:0) A ( ) ] C A ;I ; C A ;I I ; I C A ; C A L R = ; 1 5 ) C A ;I 1 (cid:0) 1 1 0 (cid:1) (cid:1) (cid:1) (cid:1) (cid:21) L R ( R 3 ) + [ 1 (cid:0) A ( ) ] [ 1 (cid:0) A ( ) ] C A ;I ; I ;C A I ; I C A ; C A + + h e r e w e u s e L R (cid:17) [ @ L R = @ (cid:17) ] = [ @ L R = @ (cid:17) ] . C A ;I C A ;t j W ;t I ;t j W ;t 0 E q u a t i o n ( 1 5 ) s h o w s h o w o u r a s s u m p t i o n s a b o u t (cid:21) d r i v e p o i n t e s t i m a t e s o f C A ;I ; 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) R . T h e s e c o n d t e r m i n t h e n u m e r a t o r , L R ( R 4 ) [ 1 (cid:0) A ( ) ] [ 1 (cid:0) A ( ) ] , C A ;I C A ;I I ; I C A ; C A 0 s e q u a l t o 0 : 0 1 . T h u s , w h e n (cid:21) ( t h e o n l y o t h e r t e r m i n t h e n u m e r a t o r ) i s c l o s e t o C A ;I ; 0 e r o , t h e n u m e r a t o r i t s e l f i s c l o s e t o z e r o . A s (cid:21) b e c o m e s s m a l l e r t h a n , s a y (cid:0) 0 : 3 5 , t h e C A ;I ; 0 u m e r a t o r o f ( 1 5 ) t a k e s o n t h e s i g n ( n e g a t i v e ) , a n d a p p r o x i m a t e l y t h e v a l u e , o f (cid:21) . C A ;I ; 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) n t h e d e n o m i n a t o r , t h e t e r m [ 1 (cid:0) A ( ) ] [ 1 (cid:0) A ( ) ] d o m i n a t e s . S i n c e I ; I C A ; C A 1 (cid:0) 1 1 (cid:1) (cid:1) (cid:1) (cid:1) 1 (cid:0) A ( ) ] [ 1 (cid:0) A ( ) ] t a k e s o n t h e v a l u e o f 0 : 6 6 f o r C a n a d a , t h i s t e r m I ; I C A ; C A 0 0 s g r e a t e r t h a n (cid:21) L R ( R 3 ) f o r a n y v a l u e w e c h o o s e t o i m p o s e o n (cid:21) i n o r d e r t o C A ;I ; I ;C A C A ;I ; d e n t i f y t h e S V A R . 0 A s a r e s u l t , e s t i m a t e s o f L R d e p e n d c r u c i a l l y o n t h e v a l u e o f (cid:21) . I f w e a s s u m e C A ;I C A ;I ; h a t (cid:1) C A d o e s n o t r e s p o n d t o (cid:1) I a t i m p a c t , w e (cid:12) n d t h e c u r r e n t a c c o u n t t o b e i n d e p e n d e n t t t 1 5

0 o f p e r m a n e n t m o v e m e n t s i n i n v e s t m e n t . H o w e v e r , w h e n w e i m p o s e (cid:21) = (cid:0) 1 u n d e r R 5 , C A ;I ; t h e c u r r e n t a c c o u n t r e s p o n d s i n a n e q u a l a n d o p p o s i t e d i r e c t i o n t o a o n e u n i t c h a n g e i n A . W ;t T h e t o p r i g h t p a n e l o f (cid:12) g u r e 1 v e r i (cid:12) e s t h i s . 3 . 6 F o r e c a s t E r r o r V a r i a n c e D e c o m p o s i t i o n s I n o r d e r t o m e a s u r e t h e i m p o r t a n c e o f w o r l d s h o c k s , (cid:17) , a n d c o u n t r y - s p e c i (cid:12) c s h o c k s , W ;t (cid:17) , f o r (cid:13) u c t u a t i o n s i n I a n d C A u n d e r t h e i d e n t i (cid:12) c a t i o n s R 1 ; R 2 , a n d R 6 , w e c o m p u t e C ;t t t f o r e c a s t e r r o r v a r i a n c e d e c o m p o s i t i o n s ( F E V D s ) . O u r c h o i c e o f i d e n t i (cid:12) c a t i o n s R 1 , R 2 , a n d R 6 f o l l o w s f r o m t a b l e 2 a n d (cid:12) g u r e 1 , w h e r e w e (cid:12) n d t h a t t h e s e i d e n t i (cid:12) c a t i o n s p r o d u c e t h e m o s t e c o n o m i c a l l y s e n s i b l e r e s u l t s . W e e s t i m a t e t h e c o n t r i b u t i o n o f , s a y , (cid:17) f o r (cid:13) u c t u a t i o n s W ;t i n I a t v a r i o u s f o r e c a s t i n g h o r i z o n s . T h i s p r o v i d e s a d d i t i o n a l e v i d e n c e o n t h e p l a u s i b i l i t y o f t t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . T a b l e 3 c o n t a i n s t h e r e s u l t s . T h e t o p p a n e l r e p o r t s t h e r e s p o n s e o f I t o (cid:17) a n d t W ;t t h e b o t t o m p a n e l r e p o r t s t h e r e s p o n s e o f C A t o (cid:17) . T h e F E V D s a r e r e p o r t e d a t h o r i z o n s t C ;t 1 5 o f z e r o , t w o , f o u r , 1 2 , a n d 2 4 q u a r t e r s . W e s u p p l y s m a l l s a m p l e s t a n d a r d e r r o r s a s w e l l . A c c o r d i n g t o t h e F E V D s r e p o r t e d i n t h e t o p r o w , u n d e r R 1 ( L R = 0 ) ; (cid:17) a c c o u n t s C A ;I W ;t f o r m o r e t h a n 7 9 p e r c e n t o f t h e v a r i a n c e o f I a t i m p a c t , a s h a r e t h a t c h a n g e s o n l y s l i g h t l y t o v e r t h e f o r e c a s t h o r i z o n . T h i s l e n d s s u p p o r t t o t h e h y p o t h e s i s t h a t I d e p e n d s m o s t l y o n t (cid:17) . T h e t o p r o w o f t h e b o t t o m p a n e l r e p o r t s t h e F E V D o f t h e c u r r e n t a c c o u n t r e s p o n s e W ;t t o (cid:17) u n d e r R 1 . T h e s e F E V D s s h o w t h a t m o r e t h a n 8 5 p e r c e n t o f t h e (cid:13) u c t u a t i o n s i n C A C ;t t a r e e x p l a i n e d b y (cid:17) a t a l l h o r i z o n s . S i n c e R 1 i m p o s e s t h a t (cid:17) e x p l a i n s 1 0 0 p e r c e n t o f t h e C ;t C ;t (cid:13) u c t u a t i o n s i n C A o n l y i n t h e l o n g r u n , t h i s p r o v i d e s s u p p o r t f o r t h e i n t e r t e m p o r a l m o d e l ’ s t h y p o t h e s i s t h a t (cid:17) d o e s n o t m a t t e r f o r m o v e m e n t s i n t h e c u r r e n t a c c o u n t . W ;t T h e s e c o n d r o w o f t h e t o p a n d b o t t o m p a n e l o f t a b l e 3 c o n t a i n t h e F E V D s u n d e r R 2 , L R = 0 . I n t h i s c a s e , a l l (cid:13) u c t u a t i o n s i n I a r e b y a s s u m p t i o n e x p l a i n e d b y (cid:17) i n t h e I ;C A t W ;t l o n g r u n . W e (cid:12) n d t h a t (cid:17) a l s o a c c o u n t s f o r n e a r l y 1 0 0 p e r c e n t o f t h e (cid:13) u c t u a t i o n s i n I a t W ;t t a l l t h e f o r e c a s t h o r i z o n s . T h e c o n t r i b u t i o n o f c o u n t r y - s p e c i (cid:12) c s h o c k s t o t h e F E V D s o f C A t u n d e r R 2 i s i n r o w t w o o f t h e b o t t o m p a n e l . W e (cid:12) n d t h a t (cid:17) a c c o u n t s f o r a b o u t 9 0 p e r c e n t C ;t o f t h e (cid:13) u c t u a t i o n s i n C A a t a l l f o r e c a s t h o r i z o n s , i m p l y i n g t h a t m o v e m e n t s i n (cid:17) d o n o t t W ;t m a t t e r f o r C A . T h i s i s c o n s i s t e n t w i t h t h e F E V D s u n d e r R 1 , a n d i s e v i d e n c e i n f a v o r o f t t h e p r e d i c t i o n o f t h e i n t e r t e m p o r a l m o d e l t h a t o n l y c o u n t r y - s p e c i (cid:12) c s h o c k s s h o u l d m a t t e r . I n t h e t h i r d r o w o f t a b l e 3 , w e p r e s e n t t h e F E V D s o f I w i t h r e s p e c t t o (cid:17) u n d e r t W ;t R 6 , L R = (cid:0) 1 . T h e s e b e g i n t o r e s e m b l e t h e F E V D s u n d e r R 1 a n d R 2 o n l y b e g i n n i n g C A ;I a t f o r e c a s t h o r i z o n s a p p r o a c h i n g s i x y e a r s . T h e F E V D s o f C A w i t h r e s p e c t t o (cid:17) u n d e r t C ;t R 6 a p p e a r i n t h e (cid:12) n a l r o w o f t a b l e 3 . A l t h o u g h (cid:17) c o n t r i b u t e s 1 0 0 p e r c e n t t o l o n g - r u n W ;t 1 5 A s S h a p ir o a n d W a t s o n ( 1 9 8 8 ) d o , w e c o m p u t e t h e s t a n d a r d e r r o r s o f t h e F E V D s b y g e n e r a t in g 1 0 0 0 b o o t s t r a p r e p lic a t io n s u s in g t h e c o v a r ia n c e m a t r ix o f t h e r e s id u a ls o f t h e r e d u c e d fo r m V A R s . T h is g iv e s t h e s t a n d a r d e r r o r s a s m a ll s a m p le in t e r p r e t a t io n a s t h e u n c e r t a in t y s u r r o u n d in g t h e F E V D p o in t e s t im a t e a t a p a r t ic u la r h o r iz o n . T o s t u d y t h e r o b u s t n e s s o f t h e b o o t s t r a p s t a n d a r d e r r o r s , w e a ls o e x a m in e d t h e M o n t e C a r lo in t e g r a t io n m e t h o d o f S im s a n d Z h a ( 1 9 9 5 ) . F o r t h e m o s t p a r t , t h is m e t h o d g e n e r a t e s s t a n d a r d e r r o r s t h a t a r e s lig h t ly s m a lle r t h a n t h e b o o t s t r a p s t a n d a r d e r r o r s . S in c e t h e la t t e r o b je c t s y ie ld a s m a ll s a m p le in t e r p r e t a t io n , w e c h o o s e t o r e p o r t t h e s e s t a n d a r d e r r o r s . 1 6

(cid:13) a c i s i o I i f p w e e (cid:12) e s i d p o e m d t a e a r i r i m a u c t u a t i o n s i n C A b y c o n s t r u c t i o n , a t i m p a c t a n d s h o r t e r f o r e c a s t h o r i z o n s , (cid:17) e x p l a i n s t W ;t t l e a s t 9 0 p e r c e n t o f C A m o v e m e n t s . T h i s s h o w s t h a t t h e r e d u c e d - f o r m c l a i m o f p e r f e c t t a p i t a l m a r k e t s i n t h e l o n g - r u n i m p l i e d b y R 6 p r o d u c e s F E V D s n o t i n a g r e e m e n t w i t h t h e n t e r t e m p o r a l m o d e l . T h e F E V D s t h a t a p p e a r i n t a b l e 3 a r e g e n e r a l l y c o n s i s t e n t w i t h t h e i n t e r t e m p o r a l , m a l l o p e n e c o n o m y m o d e l . T h e t o p p a n e l i n d i c a t e s t h a t (cid:17) c o n t r i b u t e m o r e t o (cid:13) u c t u a t i o n s W ;t n I t h a n d o c o u n t r y - s p e c i (cid:12) c s h o c k s . T h i s e v i d e n c e i s p a r t i c u l a r l y s t r i k i n g f o r I a t t h e l o w e r - t t r d e r f o r e c a s t h o r i z o n s u n d e r R 1 a n d R 2 a n d f o r t h e h i g h e r - o r d e r f o r e c a s t h o r i z o n s u n d e r R 6 . n t h e b o t t o m p a n e l o f t a b l e 3 , w e (cid:12) n d g e n e r a l l y t h a t (cid:17) c o n t r i b u t e s m o s t t o (cid:13) u c t u a t i o n s C ;t n C A . O n e c a v e a t i s t h a t t h e r e d u c e d - f o r m i d e n t i (cid:12) c a t i o n R 6 p r o d u c e s F E V D s , e s p e c i a l l y t a p r i o r i o r C A , t h a t r e (cid:13) e c t t h e r e s t r i c t i o n o f t h i s i d e n t i (cid:12) c a t i o n . t 4 . C o n c l u s i o n W e s t u d y t h e j o i n t d y n a m i c b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t d u r i n g t h e o s t - 1 9 7 5 p e r i o d , f o c u s i n g o n C a n a d a , a p r o t o - t y p e s m a l l o p e n e c o n o m y . T h e r e s t r i c t i o n s e p l a c e o n t h e d y n a m i c s a r i s e f r o m d i (cid:11) e r e n t a s p e c t s o f t h e i n t e r t e m p o r a l , s m a l l o p e n c o n o m y m o d e l . U s i n g t h e s e r e s t r i c t i o n s , w e c o n s t r u c t s i x j u s t - i d e n t i (cid:12) e d S V A R s a n d c o m p a r e a p r i o r i s t i m a t e s t o t h e p r e d i c t i o n s o f t h e i n t e r t e m p o r a l m o d e l t h a t a r e n o t i m p o s e d . W e n d t h a t i d e n t i (cid:12) c a t i o n s w i t h d i (cid:11) e r e n c e s t h a t a p p e a r i n n o c u o u s p r o d u c e d i (cid:11) e r e n t l e v e l s o f m p i r i c a l s u p p o r t f o r t h e m o d e l . I t a p p e a r s t h a t t e s t s o f t h e p r e d i c t i o n s o f t h e i n t e r t e m p o r a l , m a l l o p e n e c o n o m y m o d e l c a n b e m a d e a r b i t r a r i l y t o d e l i v e r a l m o s t a n y p a r t i c u l a r r e s u l t . P e r h a p s t h e b e s t w a y t o i n t e r p r e t o u r r e s u l t s i s t o c o n s i d e r t h e e (cid:11) e c t o f t h e d i (cid:11) e r e n t d e n t i (cid:12) c a t i o n s o n t h e j o i n t d y n a m i c b e h a v i o r o f i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . S i n c e i (cid:11) e r e n t i d e n t i (cid:12) c a t i o n s c h a n g e t h e c r o s s - e q u a t i o n r e s t r i c t i o n s p l a c e d o n t h i s d y n a m i c s y s t e m , e r t u r b a t i o n s t o t h e i d e n t i (cid:12) c a t i o n s c h e m e a l t e r t h e s e r e s t r i c t i o n s a n d a s a r e s u l t a l t e r t h e b s e r v e d e m p i r i c a l r e l a t i o n s h i p b e t w e e n i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t . A l t h o u g h t h e r e x i s t s o m e e l e m e n t s o f t h i s r e l a t i o n s h i p t h a t a r e r o b u s t a c r o s s i d e n t i (cid:12) c a t i o n s , o u r r e s u l t s a k e p l a i n t h a t t h e o b s e r v e d r e l a t i o n s h i p b e t w e e n i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t o f t e n e p e n d s f u n d a m e n t a l l y o n t h e i d e n t i (cid:12) c a t i o n . I n d e e d , o u r r e s u l t s s u g g e s t t h a t u n d e r s t a n d i n g h e e (cid:11) e c t s o f t h e i d e n t i (cid:12) c a t i o n u s e d t o c o n s t r u c t a n d i n t e r p r e t e m p i r i c a l m o d e l s o f i n v e s t m e n t n d t h e c u r r e n t a c c o u n t i s a s i m p o r t a n t a s a n a l y s i s o f t h e s a m p l i n g d i s t r i b u t i o n o f t h e s t i m a t e s . M i n u s a n a p p r e c i a t i o n o f t h e e (cid:11) e c t o f t h e i d e n t i (cid:12) c a t i o n , c l a i m s c a n b e m a d e b o u t t h e r e l a t i o n s h i p b e t w e e n i n v e s t m e n t a n d t h e c u r r e n t a c c o u n t t h a t t u r n o u t n o t t o b e o b u s t . A l t h o u g h m a n y o f o u r r e s u l t s a r e s e n s i t i v e t o s e e m i n g l y m i n o r p e r t u r b a t i o n s o f t h e d e n t i (cid:12) c a t i o n s c h e m e , t h e r e e x i s t s s o m e c o n s i s t e n c y a c r o s s i d e n t i (cid:12) c a t i o n s . W e (cid:12) n d f o u r m a i n e s u l t s , e a c h o f w h i c h h a s i m p l i c a t i o n s f o r t h e i n t e r t e m p o r a l a p p r o a c h . F i r s t , m o s t e s t i m a t e s n d i c a t e t h a t i n v e s t m e n t b o o m s a r e a s s o c i a t e d w i t h c u r r e n t a c c o u n t d e (cid:12) c i t s . S e c o n d , i n v e s t e n t i s i n d e p e n d e n t o f c o u n t r y - s p e c i (cid:12) c s h o c k s , p a r t i c u l a r l y i n t h e l o n g r u n . T h i r d , t h e s i z e n d s i g n o f t h e i m p a c t r e s p o n s e o f t h e c u r r e n t a c c o u n t t o i n v e s t m e n t ( o r w o r l d s h o c k s ) i s 1 7

s m t i r s i t t m A o t R B C E F G G J K K e n s i t i v e t o t h e i d e n t i (cid:12) c a t i o n . F i n a l l y , t h e c u r r e n t a c c o u n t e x h i b i t s a p e r s i s t e n t r e s p o n s e t o o v e m e n t s i n c o u n t r y - s p e c i (cid:12) c s h o c k s t h a t i s s t a t i s t i c a l l y s i g n i (cid:12) c a n t a n d e c o n o m i c a l l y i m p o r a n t . T h e (cid:12) r s t r e s u l t i s a f u n d a m e n t a l i m p l i c a t i o n o f t h e i n t e r t e m p o r a l m o d e l , a n d s t a n d s n c o n t r a s t w i t h t h e p r e d i c t i o n s o f t h e s t a n d a r d M u n d e l l - F l e m i n g m o d e l . S i n c e t h e s e c o n d e s u l t i m p l i e s a b a l a n c e d g r o w t h p a t h , i t c a n b e m a d e c o n s i s t e n t w i t h t h e i n t e r t e m p o r a l , m a l l o p e n e c o n o m y m o d e l w i t h l i t t l e e (cid:11) o r t . O u r t h i r d r e s u l t s u g g e s t s t h a t e s t i m a t e s o f t h e m p a c t r e s p o n s e o f t h e c u r r e n t a c c o u n t t o i n v e s t m e n t c o n t a i n l i t t l e u s e f u l i n f o r m a t i o n f o r e s t s o f t h e i n t e r t e m p o r a l , s m a l l o p e n e c o n o m y m o d e l . T h i s e c h o e s (cid:12) n d i n g s e l s e w h e r e i n h e l i t e r a t u r e . T h e (cid:12) n a l r e s u l t , t h a t t h e c u r r e n t a c c o u n t e x h i b i t s a p e r s i s t e n t r e s p o n s e t o o v e m e n t s i n c o u n t r y - s p e c i (cid:12) c s h o c k s , c o n t r a d i c t s a c e n t r a l t e n e t o f t h e i n t e r t e m p o r a l m o d e l . t p r e s e n t , t h e r e i s n o c o n s e n s u s i n t e r t e m p o r a l m o d e l t h a t g e n e r a t e s p e r s i s t e n c e i n t h e l e v e l f t h e c u r r e n t a c c o u n t . O u r e m p i r i c a l r e s u l t s t h u s s e r v e a s a r e m i n d e r o f t h e l i m i t a t i o n s o f h e i n t e r t e m p o r a l m o d e l t o e x p l a i n c u r r e n t a c c o u n t (cid:13) u c t u a t i o n s . e f e r e n c e s A m e r i c a n a x t e r , M . , a n d M . J . C r u c i n i , 1 9 9 3 , \ E x p l a i n i n g S a v i n g - I n v e s t m e n t C o r r e l a t i o n s " , E c o n o m i c R e v i e w , 8 3 , 4 1 6 (cid:0) 4 3 6 . a r d i a , E . , 1 9 9 1 , \ T h e D y n a m i c s o f S a v i n g s a n d I n v e s t m e n t i n R e s p o n s e t o M o n e t a r y , F i s c a l , J o u r n a l o f M o n e t a r y E c o n o m i c s a n d P r o d u c t i v i t y S h o c k s " , , 2 8 , 4 1 1 (cid:0) 4 3 4 . l l i o t , G . , T . J . R o t h e n b e r g , a n d J . H . S t o c k , 1 9 9 6 , \ E (cid:14) c i e n t T e s t s f o r a n A u t o r e g r e s s i v e E c o n o m e t r i c a R o o t " , , 6 4 , 8 1 3 (cid:0) 8 3 6 . e l d s t e i n , M . S . , a n d C . Y . H o r i o k a , 1 9 8 0 , \ D o m e s t i c S a v i n g s a n d I n t e r n a t i o n a l C a p i t a l E c o n o m i c J o u r n a l F l o w s " , , 9 0 , 3 1 4 (cid:0) 3 2 9 . h o s h , A . R . , 1 9 9 5 , \ I n t e r n a t i o n a l C a p i t a l M o b i l i t y A m o n g s t t h e M a j o r I n d u s t r i a l i z e d C o u n - E c o n o m i c J o u r n a l t r i e s : T o o L i t t l e o r T o o M u c h ? " , , 1 0 5 , 1 0 7 (cid:0) 1 2 8 . l i c k , R . , a n d K . R o g o (cid:11) , 1 9 9 5 , \ G l o b a l V e r s u s C o u n t r y - S p e c i (cid:12) c P r o d u c t i v i t y S h o c k s a n d J o u r n a l o f M o n e t a r y E c o n o m i c s t h e C u r r e n t A c c o u n t " , , 3 5 , 1 5 9 (cid:0) 1 9 2 . E c o n o m i c a e (cid:11) e r s o n , P . N . , 1 9 9 8 , \ O n t h e N e u t r a l i t y o f I n s i d e a n d O u t s i d e M o n e y " , , 6 4 , 5 6 7 (cid:0) 5 8 6 . E c o n o m i c Q u a r t e r ly , i n g , R . G . , a n d M . W . W a t s o n , 1 9 9 7 , \ T e s t i n g L o n g - R u n N e u t r a l i t y " , F e d e r a l R e s e r v e B a n k o f R i c h m o n d , 8 3 ( S u m m e r ) , 6 9 (cid:0) 1 0 1 . i n g , R . G . , a n d M . W . W a t s o n , 1 9 9 4 , \ T h e P o s t - W a r P h i l l i p s C u r v e : A R e v i s i o n i s t E c o n o - C a r n e g i e - R o c h e s t e r C o n f e r e n c e S e r i e s o n P u b li c P o li c y m e t r i c H i s t o r y " , , 4 1 , 1 5 7 (cid:0) 2 1 9 . 1 8

M M O O O S S S S S T T A m e r i c a n E c o n o m i c e n d o z a , E . G . , 1 9 9 1 , \ R e a l B u s i n e s s C y c l e s i n a S m a l l O p e n E c o n o m y " , R e v i e w , 8 1 , 7 9 7 (cid:0) 8 1 8 . e n d o z a , E . G . , 1 9 9 3 , \ T h e R o b u s t n e s s o f M a c r o e c o n o m i c I n d i c a t o r s o f C a p i t a l M o b i l i t y " , i n C a p i t a l M o b i l i t y : T h e I m p a c t o n C o n s u m p t i o n , I n v e s t m e n t a n d G r o w t h , R a z i n , A . , a n d L . L e i d e r m a n , e d s . , C a m b r i d g e U n i v e r s i t y P r e s s , C a m b r i d g e , U . K . . b s t f e l d , M . , 1 9 8 6 , \ C a p i t a l M o b i l i t y i n t h e W o r l d E c o n o m y : T h e o r y a n d E v i d e n c e " , C a r n e g i e - R o c h e s t e r C o n f e r e n c e S e r i e s o n P u b li c P o li c y , 2 4 , 5 5 (cid:0) 1 0 4 . b s t f e l d , M . , a n d K . R o g o (cid:11) , 1 9 9 5 , \ T h e I n t e r t e m p o r a l A p p r o a c h t o t h e C u r r e n t A c c o u n t " , o f I n t e r n a t i o n a l E c o n o m i c s , G r o s s m a n , G . M , a n d K . R o g o (cid:11) , e d s . , N o r t h - i n H a n d b o o k H o l l a n d P u b l i s h i n g C o . , N e w Y o r k . t t o , G . , 1 9 9 2 , \ T e s t i n g a P r e s e n t V a l u e M o d e l o f t h e C u r r e n t A c c o u n t : E v i d e n c e f r o m J o u r n a l o f I n t e r n a t i o n a l M o n e y a n d F i n a n c e t h e U . S . a n d C a n a d i a n T i m e S e r i e s " , , 1 1 , 4 1 4 (cid:0) 4 3 0 . B r o o k - a c h s , J . , 1 9 8 1 , \ T h e C u r r e n t A c c o u n t a n d M a c r o e c o n o m i c A d j u s t m e n t i n t h e 1 9 7 0 s " , i n g s P a p e r s o n E c o n o m i c A c t i v i t y , 1 2 , 2 0 1 (cid:0) 2 6 8 . h a p i r o , M . D . , a n d M . W . W a t s o n , 1 9 8 8 , \ S o u r c e s o f B u s i n e s s C y c l e F l u c t u a t i o n s " , i n N B E R M a c r o e c o n o m i c A n n u a l , F i s c h e r , S . , e d s . , M I T P r e s s , C a m b r i d g e , M A . h e (cid:11) r i n , S . M . , a n d W . T . W o o , 1 9 9 0 , \ P r e s e n t V a l u e T e s t s o f a n I n t e r t e m p o r a l M o d e l o f t h e J o u r n a l o f I n t e r n a t i o n a l E c o n o m i c s C u r r e n t A c c o u n t " , , 2 9 , 2 3 7 (cid:0) 2 5 3 . i m s , C . A . , a n d T . Z h a , 1 9 9 5 , \ E r r o r B a n d s f o r I m p u l s e R e s p o n s e s " , W o r k i n g P a p e r 9 5 (cid:0) 6 , F e d e r a l R e s e r v e B a n k o f A t l a n t a . t o c k , J . H . , 1 9 9 1 , \ C o n (cid:12) d e n c e I n t e r v a l s f o r t h e L a r g e s t A u t o r e g r e s s i v e R o o t i n U . S . M a c r o e - J o u r n a l o f M o n e t a r y E c o n o m i c s c o n o m i c T i m e S e r i e s " , , 2 8 , 4 3 5 (cid:0) 4 5 9 . J o u r n a l o f I n t e r - e s a r , L . L . , 1 9 9 1 , \ S a v i n g s , I n v e s t m e n t a n d I n t e r n a t i o n a l C a p i t a l F l o w s " , n a t i o n a l E c o n o m i c s , 3 1 , 5 5 (cid:0) 7 8 . r e h a n , B . , a n d C . E . W a l s h , 1 9 9 1 , \ T e s t i n g I n t e r t e m p o r a l B u d g e t C o n s t r a i n t s : T h e o r y a n d J o u r n a l o f M o n e y A p p l i c a t i o n s t o U . S . F e d e r a l B u d g e t a n d C u r r e n t A c c o u n t D e (cid:12) c i t s " , C r e d i t , a n d B a n k i n g , 2 3 , 2 0 6 (cid:0) 2 2 3 . 1 9

T X h ; e Z i m = p a D c I t ; T a e (cid:12) n R R R R R R r e s p C A . b i t 1 2 3 4 5 6 o n T l i o s h e n e e ( v 1 l o e . R L R L R (cid:21) I (cid:21) C (cid:21) C A L R n g - r u n c t o r o f S i x I d e s t r i c t i = C A ; I = I ; C A = ; C A ; 0 = A ; I ; 0 = ; I ; 0 = C A ; I m u l t i p l i e i n n o v a t i o e o r n n n (cid:0) (cid:0) ) s t i (cid:12) 0 0 0 0 1 1 o f X t o w 2 0 t o c t r a R P R P o l d N t i C A N N o e d e r e d e r Z t ( c o n R e s t r i c t i o n s I m p l i c a t i o n A (cid:17) N e u t r a l t o t W ; t i n t h e L o n g R u n I (cid:17) N e u t r a l t o t C ; t i n t h e L o n g R u n (cid:17) t I m p a c t D o e s C ; t I o t M a t t e r f o r (cid:1) t (cid:17) e c e s s a r y f o r t o W ; t C A t M a t t e r f o r (cid:1) u c e d - F o r m C l a i m f e c t C a p i t a l M a r k e i n t h e S h o r t R u n u c e d - F o r m C l a i m f e c t C a p i t a l M a r k e i n t h e L o n g R u n 0 i s d e n o t e d a s (cid:21) ( L R X ;Z ; o u n t r y - s p e c i (cid:12) c ) s h o c k s i s t o t o t X (cid:17) f s f s ;Z W ) ;t , ( w (cid:17) h C e r e ) . ;t

T a a a R f R 1 R 2 R 3 R 4 R 5 R 6 h e t a b l t e r n a t n d t h e r e b a s e 4 a n d o u r d e g (cid:21) l e c o n i v e i d b r a c k d o n R 5 , t r e e s o T a b l e I ; C A ; 0 - 0 . 5 6 : ( 0 2 7 ) - 0 . 1 1 : ( 0 2 5 ) 0 (cid:0) - 0 . 5 4 : ( 0 1 2 ) 2 . 0 6 : ( 0 7 9 ) 4 . 5 0 : ( 5 0 5 ) t a i n s e s t i m e n t i (cid:12) c a t i o n e t s c o n t a i n t h e h y p o t h h e h y p o t h e f f r e e d o m . 2 . S V (cid:21) C A ; I ; 0 0 . 0 2 : ( 0 2 0 ) - 0 . 3 0 : ( 0 1 7 ) - 0 . 3 6 : ( 0 0 8 ) 0 (cid:0) - 1 (cid:0) - 1 . 2 9 : ( 0 3 4 ) a t e s o f t h e s l i s t e d i n t p - v a l u e s . F e s i s (cid:21) C A ;I ; j s i s i s t h a t (cid:21) A p a h e o r = C A R P a r a m L R I ; C A - 0 . 6 8 : ( 0 5 0 ) 0 (cid:0) 0 . 1 7 : ( 0 4 2 ) - 0 . 6 4 : ( 0 3 5 ) 3 . 4 5 : ( 2 9 8 ) 7 . 6 9 : ( 1 3 4 4 ) r a m e t e r l i s t e d (cid:12) r s t c o l u m n . R 1 ; R 2 ; R 3 , a 0 ; j = 0 ; : = 0 ; j = ;I ; j 2 1 e t e L R - 0 ( 0 - 0 ( 0 - 0 ( 0 - 0 ( 0 i n t h S t a n d n d R 6 : : ; 4 , 0 ; : r E s t i m W C A ; I 0 (cid:0) . 2 1 : 1 9 ) . 2 6 : 1 2 ) . 0 1 : 1 3 ) . 7 5 : 1 9 ) - 1 (cid:0) e t o p r o w , u a r d e r r o r s a , t h e W a l d s a n d (cid:12) v e d e g : : ; 4 , a n d t h a t e a l d [ 1 [ 2 [ [ [ [ n d e r p p e a t a t i s r e e s e W s S t a 9 . 0 9 0 . 1 1 1 . 3 7 0 . 0 4 8 . 4 0 0 . 0 0 6 . 7 5 : 0 1 5 0 . 9 0 0 . 9 2 1 . 4 3 0 . 9 2 e a c h r i n p t i c a n o f f r e a l d s t t i s t i c ] ] ] ] ] ] o f t h e a r e n t h d p - v a e d o m . a t i s t i c s i x e s i s l u e s F o r h a s

T p f a h l a o r t e e i e n c 1 t i a 0 o n s 0 p g t 0 ( t h r b h o e T a R 1 R 2 R 6 C A R 1 R 2 R 6 o t t o m ) p e f o r e c a s r i z o n . S m p l i c a t i o n b l 7 ( 1 9 ( 3 ( 1 R t 8 ( 9 ( 1 ( a n e t e r a l l s o f e 3 . V a r i a I R e s p o n s e t t 0 2 9 . 1 4 7 7 . 5 4 8 . 6 4 ) ( 1 9 . 8 1 ) 9 . 2 7 9 8 . 9 1 : : 5 7 0 ) ( 6 1 3 ) 8 . 4 6 5 2 . 7 6 : : 7 6 4 ) ( 2 0 0 3 ) e s p o n s e t o t h 0 2 7 . 0 1 8 6 . 1 3 : : 6 8 8 ) ( 7 0 8 ) 1 . 9 4 8 9 . 6 2 : : 4 3 9 ) ( 1 5 9 7 ) 4 . 5 4 6 . 2 1 : : 9 6 1 ) ( 1 1 8 2 ) l r e p o r t s t h e c o n t r r o r v a r i a n c e o f i n v s a m p l e e m p i r i c a l s t h e S V A R t o c o m p n c e D e o t h e W 4 7 8 . 2 9 ( 1 9 . 7 0 9 9 . 0 2 : ( 6 0 0 ) 6 4 . 5 8 : ( 2 2 8 4 e C o u n t 4 8 6 . 8 7 : ( 7 4 3 ) 9 1 . 4 4 : ( 1 6 7 9 8 . 4 6 : ( 1 4 5 5 i b u t i o n o f e s t m e n t ( t t a n d a r d e r u t e t h e e m 2 2 c o m o r l d 7 ) ( 1 9 ( 5 6 ) ( 2 r y - S 8 ( 9 ) ( 1 ) ( 1 w o r l d h e c u r o r s a p i r i c a p o s i S h o c k 1 2 9 . 0 1 9 . 8 9 ) 9 . 2 0 : 8 5 7 ) 5 . 1 1 : 1 5 9 ) p e c i (cid:12) c 1 2 6 . 7 4 : 7 4 9 ) 1 . 6 4 : 7 7 2 ) 2 . 2 1 : 7 2 5 ) ( c o u n t r r r e n t a c p p e a r i n l s t a n d a t y c r i o n s 2 4 7 9 . 2 2 ( 1 9 . 9 5 9 9 . 2 5 ( 5 . 8 0 ) 9 0 . 1 3 ( 1 9 . 4 9 S h o c k 2 4 8 6 . 7 0 ( 7 . 5 8 ) 9 1 . 7 1 ( 1 7 . 9 7 1 . 0 0 ( 1 8 . 2 1 - s p e c i (cid:12) c ) o u n t ) a t p a r e n t h e d e r r o r s . ) ) ) ) s h t h e s i s . o c p W k s a r e t o t i c g e u n e l e x a r r -

Appendix This appendix contains more information about our data set and describes our estimation methods. Details about our data set appear in section A.1. Estimates of the contemporaneous correlation of the ¯rst di®erences of the current account, ¢CA , and investment ¢I t t for the rest of the G 7 economies (i:e:, France, Germany, Italy, Japan, the U.K., and the ¡ U.S.) are found in section A.2. Section A.3 discusses reduced-form VAR (RFVAR) estimation procedures and results for the entire G 7. Unit root tests and the results of these tests ¡ are furnished in section A.4. Section A.5 outlines the way in which we estimate the structural VARs (SVARs) of section 4 of the paper. Further, section A.5 provides estimates of the relevant SVAR coe±cients, forecast error variance decompositions (FEVDs), and graphical evidence for the remainder of the G 7 in support of the conclusions of the paper. ¡ A.1 Data Thepaperusesquarterlydatathatspanstheperiod1973:1 1995:4. Allofourestimates ¡ are based on the 1975:1 1995:4 sample. We require data earlier than 1975:1 for lags when ¡ computing ADF regressions and estimating VARs. Our de¯nition of investment equals the sum of gross capitalformation and the change in stocks (i:e. inventories) with one exception. TheU.S.investmentseriesincludesgrosscapitalformationofthegovernment. Thisde¯nition of investment is the same one Glick and Rogo® (1995) use. The source of the quarterly gross capital formation series is Datastream. In Datastream, this data appears in billions of constant local currency units and is seasonally adjusted at annual rates. Quarterly data for the change in stocks for the G 7 and the U.S. gross capital formation of the government ¡ series are found in the IFS data bank. The IFS provides this data in current local currency units, seasonally adjusted, at annual rates. We convert this nominal data to real data using the GDP price de°ators of the G 7. We obtain the GDP price de°ators from Datastream. ¡ Subsequent to making an adjustment to annual rates where appropriate, this completes the task of creating the investment series. Datastream reports quarterly current account data in millions of current U.S. dollars for the G 7 with the exception of the current account series for Canada, Japan, and the ¡ U.K. In Datastream, the current account series for Japan appears at the monthly frequency in millions of U.S. dollars. We temporally aggregate the monthly data to form a quarterly series. The current account series for Canada and the U.K. are provided in millions of current local currency units. All of the current account data in Datastream are seasonally adjusted with the exception of the series for France and Italy. We apply the X 11 ¯lter to ¡ seasonally adjust these series. To convert the current account series for France, Germany, Italy, and Japan to millions of constant local currency units, we apply the appropriate U.S. dollar=local currency exchange rate. The quarterly exchange rate data we employ is from the IFS and has been generously provided by Mick Devereux. Next, we use GDP de°ators to create quarterly current account series in millions of constant local currency units. The ¯nal step produces current account series for the G 7 in billions of constant local currency ¡ units at annual rates. A.1

Figures A1 and A2 contain time plots of the level of investment, I , and the level of t the current account, CA , for the G 7 economies in alphabetical order. The most striking t ¡ aspect of this data is the observed inverse relationship between I and the CA . However, t t no structural interpretation can be given to this observation. A.2 Reduced Form Univariate Regressions Atthebeginningofsection3ofthepaper,wepresentevidencethatthecontemporaneous correlation of ¢CA and ¢I for Canada matches estimates reported elsewhere. In this t t section, we present evidence that our entire G 7 data set produces similar estimates of the ¡ slope coe±cient of the regression ¢CA = b + b ¢I + À : t 0 1 t t Among others, Glick and Rogo® (1995) note that much of the literature that studies the degreeofinternationalcapitalmobilityexaminestheslopecoe±cientofthisregression. Since Glick and Rogo® report estimates of b that are less than zero, the estimates make dubious 1 the Feldstein and Horioka (1980) story of autarkic national capital markets. However, at face value the Glick and Rogo® estimates cannot be taken as evidence of perfect capital mobility internationally because these estimates of b are less negative than negative one. 1 The upper half of table A1 reproduces Glick and Rogo®'s ordinary least squares (OLS) estimates. Our results appear in the bottom half of the table. The sample period for our regression begins with 1975:1 and ends at 1995:4, while the Glick-Rogo® estimates are based on annual data from 1975 to 1990.A.1 For our estimates of b , we provide both OLS and 1 Newey-West (1994) standard errors. Our estimates of b are all negative with an average 1 estimate of 0:33. The average Glick-Rogo® estimate is about 0:39. With the exception of ¡ ¡ Germany, allofourestimatesofb aresmaller(inabsolutevalue)thanthoseGlickandRogo® 1 report. All of our estimates of b possess t ratios greater than two in absolute value.A.2 1 ¡ Thus,ourestimatesofthereducedformregressionsindicatethatthecorrelationbetween ¢CA and ¢I in our data set is similar to that found by other researchers. To reiterate our t t discussion just before section 3.1 of the paper, no structural interpretation can be given to these estimates without an identi¯cation scheme. A.3 Reduced-Form VAR Estimation The results of estimating the reduced form VAR of ¢CA and ¢I appear in tables t t A2:1 2. For each G 7 member, we compute OLS estimates of the fourth-order VAR ¡ ¡ A.1Estimatesforthe1975:1 1990:4samplearequalitativelysimilartothoseforthe1975:1 1995:4sample. ¡ ¡ A.2Themajor di®erencebetweenour estimatesandthoseofGlickandRogo®istheR2 andDurbin-Watson (D W)statistics. For sixofthesevenregressions,thevalueofR2 wereportissmaller than thoseinthetop ¡ panel of table A1. On the other hand, the Glick-Rogo® D W statistics are smaller than ours. Most likely, ¡ the source of these di®erences is temporal aggregation. A.2

(A3.1) ¢I = A (L)¢I + A (L)¢CA + " ; t ¢I;¢I t 1 ¢I;¢CA t 1 ¢I;t ¡ ¡ and (A3.2) ¢CA = A (L)¢I + A (L)¢CA + " : t ¢CA;¢I t 1 ¢CA;¢CA t 1 ¢CA;t ¡ ¡ We estimate the reduced form VAR of (A3.1) and (A3.2) by ordinary least squares (OLS). These results appear in table A2:1. The Granger-causality tests we present in table A2:1 follow the advice of Hamilton (1994) and construct a test statistic that asymptotically possesses the Â2 distribution with four degrees of freedom. To compute the forecast errors and shocks to the stochastic trends that appear in table A2:2, we estimate a slightly altered reduced form VAR. In this instance, we write equations (A3.1) and (A3.2) as (A3.3) ¢I = A (1)¢I + A (L)¢2I t ¢I;¢I t 1 ¢I;¢I t 1 ¡ ¡ + A (1)¢CA + A (L)¢2CA + " ; ¢I;¢CA t 1 ¢I;¢CA t 1 ¢I;t ¡ ¡ and (A3.4) ¢CA = A (1)¢I + A (L)¢2I t ¢CA;¢I t 1 ¢CA;¢I t 1 ¡ ¡ + A (1)¢CA + A (L)¢2CA + " ; ¢CA;¢CA t 1 ¢CA;¢CA t 1 ¢CA;t ¡ ¡ where the lag operators are of order p 1. Standard deviations of the forecast errors ¡ and their correlations are calculated from the OLS residuals of the regressions (A3.3) and (A3.4) for all of the G 7 economies. To generate the standard deviations of the stochastic ¡ trends and their correlation for the G 7, we combine the OLS estimates of the coe±cients ¡ A (1); A (1); A (1), and A (1) with the covariance matrix of the ¢I;¢CA ¢I;¢I ¢CA;¢I ¢CA;¢CA reduced form OLS residuals of the regressions (A3.3) and (A3.4). We follow King and Watson (1997) and compute the standard errors of the stochastic trends and their correlation by the delta method. In table A2:1, we report sums of the estimated coe±cients of equations (A3.1) and (A3.2), their standard errors, LM tests, and Granger-causality tests. Although there are some noticeable patterns across the G 7 in the signs of these sums of coe±cients, only those ¡ for Japan and the U.K. have a t ratio greater than two. For Japan, the coe±cient sums ¡ with a t ratio greater than two are the autoregressive parameters of equations (A3.1) and ¡ (A3.2). For the U.K., the coe±cient sums with t ratios greater than two (in absolute terms) ¡ are in equation (A3.2), the ¢CA regression. t Results of the LM and Granger-causality tests produce a similar picture. The LM test computes the statistic T R2 to provide information about the hypothesis that all of the £ slopecoe±cientsofeitherequation(A3.1)orequation(A3.2)arejointlyequaltozero. Inthis A.3

case, the test statistic is asymptotically distributed Â2 with eight degrees of freedom. Of the 14 regressions, only four regressions, the ¢I regression for Japan and the ¢CA regressions t t for France, the U.K. and the U.S., reject the hypothesis at the ¯ve percent signi¯cance level. Likewise, the tests for Granger-causality suggest that ¢CA possesses no forecasting power for ¢I across the G 7. On the other hand, using equation (A3.2) to test the hypothesis ¡ that A (j) = 0; j = 1; :::; 4, yields evidence that is a bit more mixed. In this ¢CA;¢I case, ¢I possesses forecasting power for ¢CA for France, the U.K., and the U.S. at the ¯ve percent signi¯cance level or better. These Granger-causality tests lend some support for the notion that lags of ¢I do not matter for ¢CA , as implied by the intertemporal, t t small open economy model. There exists stronger evidence that lags of ¢CA do not predict t movements in ¢I .A.3 Taken together with the estimates of the coe±cient sums, the results t of the LM tests and the Granger-causality tests appear to support the inference that, except for Japan, ¢I is to a ¯rst approximation white noise, but that ¢CA is white noise for t t Canada, Germany, and Italy, at least, in the context of the RFVAR of (A3.1) and (A3.2). The top panel of table 2:2 contains summary statistics of the one-step ahead forecast errors. Except for the U.K., the standard deviation of the innovation of the ¢I regression t is greater than that for the ¢CA regression for all G 7 economies. In addition, all of t ¡ the estimated standard deviations possess t ratios greater than two. As expected, the con- ¡ temporaneous correlation between the innovations of ¢I and ¢CA regressions is negative. t t Aside from the U.K., the absolute value of the t ratios of these correlations is less than two. ¡ At short horizons, news about unrestricted forecasts of ¢I and ¢CA are orthogonal. t t Estimates of the stochastic trends appear in the bottom panel of table 2:2. For the entire G 7, the standard deviation of the permanent component of the innovation of the ¡ ¢I regression is greater than the same statistic for the ¢CA regression. Among this set of t t standard deviations, the standard deviation of the permanent component of the innovation ofthe¢I regressionfortheU.K.possesses thesmallestt ratio of1:94. Foreach oftheG 7, t ¡ ¡ the contemporaneous correlation between the permanent innovations in the ¢I and ¢CA t t regressions is negative. However, only the t ratios for Italy, the U.K., and the U.S. are ¡ greater than two (in absolute terms). This suggests that unrestricted long-run movements in I and CA have a common source. t t A.4 Unit Root Tests Elliot, Rothenberg, and Stock (1996) present a method to test for a unit root in the presence of a deterministic mean or trend that is asymptotically more powerful than the usual DF t ratio. This method begins by estimating the regression y = ¯ + ¯ t + ! . t 0 1 t ¡ ^ ^ The next step constructs the predicted values of !^ = y ¯ ¯ t to use in the t t 0 1 ¡ ¡ augmented DF regression A.3She®rin and Woo (1990), Otto (1992) and Ghosh (1995) present similar Granger-causality results for these countries. However, the regressions these authors estimate use the CA instead of ¢CA . t t A.4

k !^ = ½!^ + # ¢!^ + u ; t t 1 j t j t;k ¡ ¡ j=1 X where the lag length, k, is chosen using the BIC criterion to render u white noise.A.4 The t GLS-DF t ratio is constructed using the OLS estimates of ½ and its standard error. Elliot, ¡ Rothenberg, and Stock provide asymptotic ten percent, ¯ve percent, and one percent critical values for the GLS-DF t ratio equal to 2:57, 2:89, and 3:48, respectively. ¡ ¡ ¡ ¡ We present OLS estimates of the standard ADF t ratio using the regression ¡ k y = Ã + Ã t + °y + » ¢y + e ; t 0 1 t 1 j t j t ¡ ¡ j=1 X where the lag length, k, is chosen to render e white noise. The lag length, k, is chosen t using the Campbell and Perron (1991) rule. This rule selects a maximum k a priori and then discards lags until the t ratio of ¢y becomes less than 1:6 (in absolute value). t k ¡ ¡ MacKinnon (1991) provides asymptotic ten percent, ¯ve percent, and one percent critical values for the DF t ratio equal to 3:13, 3:41, and 3:96, respectively. ¡ ¡ ¡ ¡ Unit root tests are often criticized because of power problems these tests have, for example, with trend stationary alternatives.A.5 Another problem that face unit root tests is an inability to provide information about the sampling variability of the estimate of °. Stock (1991) presents the results of Monte Carlo simulations that are the building blocks for the construction of asymptotic con¯dence intervals. We present 95 percent asymptotic con¯dence intervals using the ADF regression with an intercept and a linear trend. As Stock suggests, we use linear interpolation to construct the asymptotic con¯dence intervals of °. A.5 SVAR Estimation Methods Our estimation strategy follows closely that of King and Watson (1997). Since the appendix King and Watson (1997) supply contains a large amount of detail about their estimation methods, this section of our appendix provides only a brief sketch of the way in which we adapt these estimation methods. In particular, this section includes a description of the methods we use to estimate the SVAR when either or serves as the I;CA CA;I LR LR identifying restriction. To estimate a SVAR when a long run multiplier acts as the identifying restriction, King and Watson (1997) use the technique of rewriting a regression to include second di®erence terms. When identi¯es the SVAR, we develop the bivariate system to estimate by I;CA LR writing equation (9) as A.4To choose the lag length, the BIC criterion, ln[¾^2 ] + (k=T)ln[T], is minimized over k. u;k A.5Theseproblems areatthecenter ofthedebateof thesourceofthe trendin realU.S.GNP.Diebold and Senhadji (1996) and Nelson and Murray (1997) present contrasting views of this issue. A.5

(A5.1) ¢I = ¸ (1)¢CA + ¸ (1)¢I t I;CA t I;I t 1 ¡ + ¤ (L)¢2I + ¤ (L)¢2CA + ´ ; I;I t 1 I;CA t 1 W;t ¡ ¡ where, for example, p 1 p ¤ (L)¢2I = ¡ ¸ ¢2I : I;I t 1 I;I;s t j ¡ ¡ 0 1 ¡ j=1 s=j+1 X X @ A From (9), it follows that = ¸ (1)=[1 ¸ (1)]. With a bit of algebra, this I;CA I;CA I;I LR ¡ yields the regression (A5.2) ¢I ¢CA = ¸ (1)[¢I ¢CA ] t I;CA t I;I t 1 I;CA t ¡ LR ¡ ¡ LR + ¤ (L)¢2I + ¤ (L)¢2CA + ´ : I;I t 1 I;CA t 1 W;t ¡ ¡ Since ¢CA can be correlated with ´ , we compute the coe±cients of this equation with t W;t an IV estimator using the instruments ¢I ; ¢CA p for the G 7 economies. With f t ¡ j t ¡ j gj=1 ¡ the coe±cient estimates of the regression of (A5.2) in hand, we estimate equation (10) by IV with the instruments ¢I ; ¢CA p and ´^ . The instrument ´^ denotes the f t ¡ j t ¡ j gj=1 W;t W;t residuals of regression (A5.2). Weuse a symmetric procedure when serves to identify CA;I LR the SVAR. Across the G 7, the standard errors of the estimates of and are I;CA CA;I ¡ LR LR computed using the delta method. Another issue we face is that the procedure just described uses a generated regressor, ´^ , as an instrument to estimate equation (10). The generated regressor problem arises W;t because the variables on the right hand side of equation (10) and ´^ may be correlated. As W;t a result, an adjustment is needed to the estimator of the covariance matrix of the coe±cients of equation (10). King and Watson (1997) present the details of the adjustment to this covariance matrix. We do not duplicate their e®orts here. To compute the empirical standard errors of the FEVDs we report in tables 3 and A5:1 3,theMonteCarloprocedurebeginswithestimatesoftheintercepts,slopecoe±cients, ¡ and the covariance matrix of the residuals of the RFVAR of equations (A3.1) and (A3.2) for each member of the G 7. Using these reduced-form estimates, we generate 1000 pairs of ¡ normally distributed, mean zero random variates. The covariance matrix of these random variates equals the covariance matrix of the reduced-form residuals. From these synthetic residuals and the estimated intercepts and slope coe±cients we build up arti¯cial I and t the CA series. Next, we estimate the SVARs under the identi¯cations of R1, R2, and R6 t using these 1000 replications. The estimates of the SVAR using the arti¯cial data allows us to construct the small sample standard errors of the FEVDs. Since this procedure builds the Monte Carlo up from the distribution of the RFVAR residuals, the standard errors of A.6

the FEVDs possesses only an interpretation as draws from the small sample or empirical distribution of the joint dynamic process that generates I and the CA . t t A.6 SVAR Results for the G-7 sans Canada Tables A4:1 3 contain point estimates of ¸ ; ¸ ; , and as well I;CA;0 CA;I;0 I;CA CA;I ¡ LR LR as Wald statistics that test a key prediction of the intertemporal model under restrictions R1 R6 for theG 7 minus Canada. The point estimates we present in thesetables reinforce ¡ ¡ the results for Canada of table 2. These results are that (a) estimates of back the inference that only the common world shock, ´ , I;CA W;t LR drive permanent °uctuations in I , t (b) estimates of the impact coe±cients ¸ and ¸ are sensitive to the identi- I;CA;0 CA;I;0 ¯cation scheme, (c) estimates of are closely tied to the value of ¸ , and CA;I CA;I;0 LR (d) rejections of the hypothesis of the intertemporal, small open economy prediction that movements in the CA are independent of ´ and its lags depend on the choice of the t W;t identi¯cation scheme. Support for item (a) arise in tables A4:1 3 because of the t ratios the estimates of ¡ ¡ imply. Of the 30 estimates of that appear in these tables, only six yield a I;CA I;CA LR LR t ratio greater than two in absolute value (see the top panel of table A4:1 and the bottom ¡ panel of table A4:2). Italy and the U.K. produce two-thirds of these estimates. Item (b) stands out clearly from an inspection of tables A4:1 3. For example, under ¡ R1(the top panel of table A4:1) all the estimates of ¸ are negative and four of the I;CA;0 six estimates possess t ratios greater than two in absolute value. However, under R2(the ¡ bottom panel of table A4:1) four of the six estimates of ¸ are positive and none of these I;CA;0 estimates are statistically di®erent from zero at any reasonable signi¯cance level. We show in section 3.5 of the paper that estimates of are tied either to the CA;I LR identi¯cation of ¸ or its point estimate. The estimates of we report in tables CA;I;0 CA;I LR A4:1 3 bolster this analysis. This observation marks the basis for item (c). Except for the ¡ identi¯cation scheme R2(see the bottom panel of table A4:1), country-by-country estimates of are quite close to the value of ¸ given an identi¯cation. CA;I CA;I;0 LR Casual inspection of theWald statistics of tables A4:1 3 is enough to clinch support for ¡ item(d). TheWald statistics thatidenti¯cations R1 andR3 generatemakethisplain. Under R1 the null hypothesis of (12) is only rejected by the French data (see the top panel of table A4:1). However, this hypothesis receives strong rejections by data from France, Germany, Italy, the U.K., and the U.S. under R3 (see the top panel of table A4:2). The Wald statistics continue to back our thesis that tests of many of the predictions of the intertemporal model yield inferences sensitive to the identi¯cation. The forecast error variance decompositions (FEVD) lend support to item (a). When = 0isnotimposedastheidentifying restriction (i:e., R2),we¯nd thatthecommon I;CA LR world shock ´ explains more than 65 percent of the variation in I at a 24 quarter forecast W;t t A.7

horizon in eight of the remaining 12 FEVDs. In the case of R2, the FEVDs of I reveals t that anywhere from 95 to 100 percent can be attributed to ´ at impact (see the top panel W;t of table A5:2). The FEVDs of I for France, Germany, Italy, Japan, the U.K., and the U.S. t that we report in the top panels of tables A5:1 3 provide economically meaningful evidence ¡ that a shock common to the G 7 contributes most to °uctuation in I . This evidence is t ¡ particularly strong at longer forecast horizons. Tables A5:1 3 also contain results that help to sustain ourclaimthat thepersistencein ¡ the CA of the G 7 is an important and neglected aspect of the intertemporal approach to t ¡ the current account. Under R1(see the bottom panel of table A5:1), country-speci¯c shocks in the form of ´ generate about three-fourths or more of movements in the CA from C;t t impact to a forecast horizon of one year for the G 7 minus Canada. Since R1 restricts long- ¡ run °uctuations in the CA to respond only to ´ , it is expected that the analogous FEVDs t C;t at the longer forecast horizons should approach 100 percent. In this regard, the FEVDs in the bottom half of table A5:2 are particularly striking. These FEVDs are calculated under a long-runidentifying restrictionimposedonI ,R2. Givennorestrictiononthebehaviorofthe t CA , we ¯nd that about 60 percent or more of the variation in this variable is explained by t ´ at all forecast horizons for all six economies. The reduced-form long-run identi¯cation C;t of R6 reverses this result. The bottom half of table A5:3 contains only one FEVD that possesses a t ratio greater than two (see the impact FEVD for the U.K.) and none of these ¡ FEVDs is greater than 32 percent. Our analysis of section 3.5 of the paper resolves the disparate results of the FEVDs of the CA we report in the bottom panels of tables A5:1 3. This analysis outlines the close t ¡ connection between identi¯cations that impose a restriction on the behavior of CA within t the SVAR of (9) and (10) and the estimated unrestricted behavior of the CA . As a result, t we should expect to observe FEVDs in which only ´ should matter for the CA under R1. C;t t The FEVDs of the bottom panel of table A5:1 back this expectation. Likewise, under R6, we should anticipate that only common world shocks are responsible for °uctuations in the CA as we observe in the bottom panel of table A5:3. Hence, the FEVDs of the CA under t t R2(see the bottom panel of table A5:2) are a strong signal for the importance of ´ and C;t the impact of these shocks on the persistence of the CA . t Figures A3 8 and A9 14 replicate ¯gures 1 and 2 of the paper, respectively. By and ¡ ¡ large, the information that ¯gures A3 8 and A9 14 contain reinforce the discussion we ¡ ¡ present in the paper for ¯gures 1 and 2. That is, the 95 percent con¯denceintervals of ¯gures A3 8 show that the identi¯cation matters for inference about R1 and R6. These ¯gures ¡ are in line with ¯gure 1 because support for the restriction of R6 exists only when ¸ CA;I;0 is close to negative one. The 95 percent con¯dence ellipses of ¯gures A9 14 provide more ¡ evidence to back our conclusion that minor changes to the identi¯cation leads to di®erent views of the e±cacy of the intertemporal, small open economy model. A.8

References Campbell, J.Y., and P. Perron, 1991, \Pitfalls and Opportunities: What Macroeconomics Should Know about Unit Roots", in NBER Macroeconomic Annual, Blanchard, O.J, and S. Fischer, eds., MIT Press, Cambridge, MA. Diebold, F.X., and A.S. Senhadji, 1996, \The Uncertain Unit Root in Real GNP", American Economic Review, 86, 1291 1298. ¡ Elliot, G., T.J. Rothenberg, and J.H. Stock, 1996, \E±cient Tests for an Autoregressive Root", Econometrica, 64, 813 836. ¡ Feldstein, M.S., and C.Y. Horioka, 1980, \Domestic Savings and International Capital Flows", Economic Journal, 90, 314 329. ¡ Ghosh, A.R., 1995, \InternationalCapitalMobilityAmongsttheMajor Industrialized Countries: Too Little or Too Much?", Economic Journal, 105, 107 128. ¡ Glick, R., and K. Rogo®, 1995, \Global Versus Country-Speci¯c Productivity Shocks and the Current Account", Journal of Monetary Economics, 35, 159 192. ¡ Hamilton, J.D., 1994, Time Series Analysis, Princeton University Press, Princeton, NJ. King, R.G., and M.W. Watson, 1994, \The Post-War Phillips Curve: A Revisionist Econometric History", Carnegie-Rochester Conference Series on Public Policy, 41, 157 219. ¡ King, R.G., and M.W. Watson, 1997, \Testing Long-Run Neutrality", Economic Quarterly, Federal Reserve Bank of Richmond, 83(Summer), 69 101. ¡ MacKinnon, J.G., 1991, \Critical Values for Cointegration Tests", in Long-Run Economic Relationships, Readings in Cointegration, Engle, R.F., and C.W.J. Granger, eds., Oxford University Press, Oxford, U.K.. Nelson, C.R., and C.J. Murray, 1997, \The Uncertain Trend in U.S. GNP", mimeo, Department of Economics, University of Washington. Newey, W.K., and K.D. West, 1994, \Automatic Lag Selection in Covariance Matrix Estimation", Review of Economic Studies, 61, 631 654. ¡ Otto, G., 1992, \Testing a Present Value Model of the Current Account: Evidence from the U.S. and Canadian Time Series", Journal of International Money and Finance, 11, 414 430. ¡ She®rin, S.M., and W.T. Woo, 1990, \Present Value Tests of an Intertemporal Model of the Current Account", Journal of International Economics, 29, 237 253. ¡ Stock, J.H., 1991, \Con¯dence Intervals for the Largest Autoregressive Root in U.S. Macroeconomic Time Series", Journal of Monetary Economics, 28, 435 459. ¡ A.9

Table A1. Reduced Form Univariate Regressions ¢CA = b + b ¢I + À t 0 1 t t Glick and Rogo® Results Sample Period: 1975 1990 ¡ Canada France Germany Italy Japan U.K. U.S. ^ b -0.30 -0.42 -0.23 -0.59 -0.37 -0.60 -0.20 1 (0:10) (0:12) (0:19) (0:10) (0:10) (0:10) (0:09) R2 0.38 0.47 0.10 0.71 0.49 0.72 0.27 D W 1.88 1.42 1.60 1.19 1.54 1.81 1.18 ¡ Results Using Quarterly Data Sample Period: 1975:1 1995:4 ¡ Canada France Germany Italy Japan U.K. U.S. ^ b -0.37 -0.37 -0.33 -0.43 -0.20 -0.54 -0.11 1 (0:08) (0:09) (0:09) (0:09) (0:08) (0:11) (0:04) [0.07] [0.09] [0.15] [0.11] [0.06] [0.09] [0.04] R2 0.20 0.17 0.13 0.22 0.07 0.22 0.09 D W 2.34 2.46 2.50 2.36 1.64 2.72 2.20 ¡ The Glick and Rogo® (1995) estimates, taken from the bottom panel of their table 1, are based on annual data. We use OLS to compute estimates of the slope coe±cient b as do 1 Glick and Rogo®. OLS standard errors appear in parenthesis. The values in brackets are Newey-West corrected standard errors. The Newey-West standard errors are constructed using an automatic lag length adjustment. A.10

Table A2.1 Reduced Form VARs Sample Period: 1975:1 1995:4 ¡ Coe±cient Sums and Tests of Predictive Content Canada France Germany Italy Japan U.K. U.S. A (1) 0.07 0.31 -0.16 0.00 0.46 0.18 -0.09 ¢I;¢I (0.23) (0.20) (0.28) (0.22) (0.14) (0.30) (0.24) A (1) 0.16 0.30 -0.28 0.05 -0.03 -0.02 -0.26 ¢I;¢CA (0.37) (0.34) (0.33) (0.30) (0.22) (0.36) (0.72) A (1) -0.02 -0.10 0.14 -0.26 -0.02 -0.93 -0.13 ¢CA;¢I (0.19) (0.17) (0.26) (0.22) (0.12) (0.32) (0.09) A (1) -0.42 -0.51 0.04 -0.26 0.37 -1.12 -0.04 ¢CA;¢CA (0.30) (0.29) (0.31) (0.29) (0.18) (0.38) (0.26) ¢I Regression : R2 0.09 0.11 0.15 0.15 0.36 0.03 0.09 [0.44] [0.34] [0.12] [0.14] [0.00] [0.95] [0.44] ¢CA Regression : R2 0.11 0.19 0.07 0.06 0.10 0.20 0.21 [0.31] [0.04] [0.66] [0.76] [0.42] [0.03] [0.02] Wald Test: ¢CA ¢I : 2.77 3.46 7.40 6.73 5.81 0.49 0.36 ! [0.60] [0.48] [0.12] [0.15] [0.21] [0.97] [0.99] Wald Test: ¢I ¢CA : 6.75 11.05 1.29 3.72 1.37 10.46 9.51 ! [0.15] [0.03] [0.86] [0.45] [0.85] [0.03] [0.05] Standard errors appear in parenthesis. The values in brackets are p-values. The p-values that appear below the R2s represent signi¯cance levels for the LM test statistic T R2. £ These statistics are asymptotically distributed Â2 with eight degrees of freedom. The Wald statistics that tests the predictive power of either ¢I for ¢CA or ¢CA for ¢I possess a Â2 distribution with four degrees of freedom asymptotically. A.11

Table A2.2 Reduced Form VARs Sample Period: 1975:1 1995:4 ¡ Forecast Errors Canada France Germany Italy Japan U.K. U.S. ¾(" ) 4.40 21.64 22.25 10716.18 1639.38 4.22 58.04 ¢I (1.03) (5.06) (5.20) (2502.97) (382.91) (0.98) (13.56) ¾(" ) 3.60 18.40 20.75 10332.76 1312.30 4.45 21.05 ¢CA (0.84) (4.30) (4.85) (2413.41) (306.51) (1.04) (4.92) Corr(" ; " ) -0.44 -0.40 -0.46 -0.49 -0.23 -0.51 -0.35 ¢I ¢CA (0.27) (0.28) (0.26) (0.25) (0.31) (0.24) (0.29) Shocks to Stochastic Trends Canada France Germany Italy Japan U.K. U.S. ¾(" ) 4.54 28.79 21.32 10409.73 3096.24 5.26 56.84 I (1.49) (10.80) (5.28) (3741.63) (1279.11) (2.71) (17.22) ¾(" ) 2.54 12.86 19.79 9369.82 2104.67 3.85 24.11 CA (0.67) (3.01) (8.67) (2269.92) (889.18) (0.51) (10.81) Corr(" ; " ) -0.37 -0.39 -0.54 -0.63 -0.30 -0.88 -0.65 I CA (0.38) (0.45) (0.35) (0.26) (0.45) (0.28) (0.26) Standard errors appear in parenthesis. A.12

Table A3. Unit Root Tests Sample Period: 1975:1 1995:4 ¡ Investment Canada France Germany Italy Japan U.K. U.S. DF-GLS t ratio 2:64 1:80 1:48 3:88 2:56 1:82 3:37 ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ Lag Length 1 1 1 2 3 1 1 ADF t ratio 2:78 2:40 1:67 4:07 1:99 2:11 3:90 ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ Lag Length 1 2 0 2 3 0 3 ADF AR Root 0.85 0.90 0.93 0.74 0.96 0.90 0.73 95% CI: LL 0.73 0.79 0.89 0.85 0.83 ¡¡ ¡¡ 95% CI: UL 1.04 1.05 1.06 0.90 1.05 1.05 0.93 Current Account Canada France Germany Italy Japan U.K. U.S. DF-GLS t ratio 1:72 2:81 1:41 1:80 2:41 2:15 1:88 ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ Lag Length 1 1 1 1 2 1 1 ADF t ratio 2:00 3:41 1:86 2:30 2:39 2:57 1:84 ¡ ¡ ¡ ¡ ¡ ¡ ¡ ¡ Lag Length 0 0 4 0 2 1 3 ADF AR Root 0.87 0.75 0.91 0.86 0.91 0.85 0.92 95% CI: LL 0.85 0.61 0.86 0.80 0.79 0.76 0.87 95% CI: UL 1.05 1.02 1.05 1.05 1.05 1.04 1.05 The asymptotic ten percent, ¯ve percent, and one percent critical values for the GLS-DF (ADF) t ratio equal 2:57( 3:13), 2:89( 3:41), and 3:48( 3:96), respectively. ¡ ¡ ¡ ¡ ¡ ¡ ¡ A.13

Table A4.1 Structural VARs Sample Period: 1975:1 1995:4 ¡ R1 : = 0 CA;I LR France Germany Italy Japan U.K. U.S. ¸ -0.64 -0.37 -0.70 -0.33 -0.97 -1.68 I;CA;0 (0.30) (0.24) (0.19) (0.34) (0.23) (0.58) ¸ 0.15 -0.12 0.26 0.03 1.15 0.12 CA;I;0 (0.28) (0.21) (0.25) (0.22) (0.71) (0.09) -0.88 -0.58 -0.70 -0.44 -1.21 -1.54 I;CA LR (0.66) (0.32) (0.25) (0.54) (0.20) (0.59) Wald Statistic 11.64 1.48 2.86 6.80 3.69 7.24 [0.04] [0.92] [0.72] [0.24] [0.59] [0.20] R2 : = 0 I;CA LR France Germany Italy Japan U.K. U.S. ¸ -0.20 0.30 -0.04 0.05 0.01 0.25 I;CA;0 (0.21) (0.40) (0.24) (0.36) (0.17) (0.72) ¸ -0.21 -0.61 -0.44 -0.21 -0.54 -0.15 CA;I;0 (0.17) (0.24) (0.20) (0.23) (0.17) (0.09) -0.18 -0.50 -0.57 -0.20 -0.65 -0.28 CA;I LR (0.18) (0.21) (0.19) (0.26) (0.12) (0.22) Wald Statistic 14.40 8.13 9.96 2.31 24.24 13.94 [0.01] [0.15] [0.08] [0.80] [0.00] [0.02] Inthe topand bottompanels, standard errorsappear in parenthesis andthe brackets contain p-values. The Wald statistic and p-values in the top and bottom panel are based on the hypothesis ¸ = 0; j = 0; :::; 4, and ¯ve degrees of freedom. CA;I;j A.14

Table A4.2 Structural VARs Sample Period: 1975:1 1995:4 ¡ R3 : ¸ = 0 I;CA;0 France Germany Italy Japan U.K. U.S. ¸ -0.34 -0.43 -0.47 -0.18 -0.53 -0.12 CA;I;0 (0.08) (0.09) (0.09) (0.08) (0.10) (0.04) 0.44 -0.24 0.05 -0.06 -0.02 -0.24 I;CA LR (0.58) (0.26) (0.31) (0.41) (0.43) (0.63) -0.24 -0.32 -0.59 -0.18 -0.64 -0.25 CA;I LR (0.10) (0.20) (0.14) (0.18) (0.10) (0.08) Wald Statistic 29.69 23.80 31.50 6.21 43.12 22.30 [0.00] [0.00] [0.00] [0.29] [0.00] [0.00] R4 : ¸ = 0 CA;I;0 France Germany Italy Japan U.K. U.S. ¸ -0.48 -0.49 -0.50 -0.29 -0.48 -0.96 I;CA;0 (0.12) (0.10) (0.10) (0.13) (0.09) (0.28) -0.56 -0.69 -0.52 -0.39 -0.82 -1.04 I;CA LR (0.43) (0.23) (0.21) (0.40) (0.19) (0.53) -0.07 0.15 -0.21 -0.02 -0.44 -0.13 CA;I LR (0.11) (0.30) (0.14) (0.18) (0.11) (0.07) Wald Statistic 11.05 1.29 3.72 1.37 10.46 9.52 [0.03] [0.86] [0.44] [0.85] [0.03] [0.05] Inthe topand bottompanels, standard errorsappear in parenthesis andthe brackets contain p-values. The Wald statistic and p-values in the top (bottom) panel are based on the hypothesis ¸ = 0; j = 0; :::; 4 (j = 1; :::; 4), and ¯ve (four) degrees of freedom. CA;I;j A.15

Table A4.3 Structural VARs Sample Period: 1975:1 1995:4 ¡ R5 : ¸ = 1 CA;I;0 ¡ France Germany Italy Japan U.K. U.S. ¸ 1.73 1.29 1.15 1.79 0.80 151.88 I;CA;0 (0.61) (0.47) (0.43) (0.52) (0.31) (985.90) 5.75 0.71 2.16 2.16 26.96 -8.37 I;CA LR (6.35) (0.74) (2.20) (1.85) (254.35) (5.93) -0.66 -0.82 -1.04 -0.83 -0.82 -0.93 CA;I LR (0.17) (0.20) (0.20) (0.31) (0.10) (0.42) Wald Statistic 2.91 12.77 7.96 10.37 10.68 11.22 [0.57] [0.01] [0.09] [0.03] [0.03] [0.02] R6 : = 1 CA;I LR ¡ France Germany Italy Japan U.K. U.S. ¸ 4.55 2.49 1.00 2.49 3.02 -132.86 I;CA;0 (4.87) (2.55) (0.76) (2.06) (3.80) (1836.17) ¸ -1.42 -1.26 -0.95 -1.22 -1.49 -1.10 CA;I;0 (0.38) (0.37) (0.21) (0.54) (0.41) (0.79) 34.23 1.38 1.78 3.09 -3.18 -7.48 I;CA LR (192.75) (1.78) (2.30) (3.97) (2.14) (7.08) Wald Statistic 2.94 9.61 8.37 7.89 9.09 9.20 [0.71] [0.09] [0.09] [0.16] [0.10] [0.10] Inthe topand bottompanels, standard errorsappear in parenthesis andthe brackets contain p-values. The Wald statistic and p-values in the top (bottom) panel are based on the hypothesis ¸ = 0; j = 1; :::; 4 (j = 0; :::; 4), and four (¯ve) degrees of freedom. CA;I;j A.16

Table A5.1 FEVD under R1 : = 0 CA;I LR Investment Response to the World Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 70.96 88.30 56.76 93.00 22.62 65.60 (22.19) (16.95) (19.37) (17.18) (15.92) (18.12) 2 70.89 88.06 56.76 93.00 17.42 65.40 (22:36) (17:25) (19:37) (17:19) (15:11) (18:22) 4 70.89 88.19 56.76 93.00 16.73 65.40 (22:34) (17:29) (19:37) (17:19) (14:43) (18:22) 12 71.09 88.33 56.76 93.00 16.87 65.31 (22:25) (17:33) (19:37) (17:19) (13:68) (18:25) 24 71.15 88.40 56.76 93.00 16.93 65.29 (22:16) (17:35) (19:37) (17:19) (13:59) (18:25) Current Account Response to the Country-Speci¯c Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 97.69 98.43 95.86 99.88 73.25 92.75 (11.37) (8.42) (9.16) (11.23) (15.94) (10.24) 2 97.88 98.11 95.86 99.88 75.30 93.34 (11:27) (8:69) (9:16) (11:23) (16:32) (9:86) 4 97.82 98.14 95.86 99.88 76.02 93.30 (11:39) (8:68) (9:16) (11:23) (15:78) (10:03) 12 97.71 98.12 95.86 99.88 77.74 93.36 (11:07) (8:70) (9:16) (11:23) (14:02) (10:06) 24 97.68 98.13 95.86 99.88 78.34 93.37 (10:99) (8:70) (9:16) (11:23) (13:59) (10:38) In the top and bottom panels, small sample empirical standard errors appear in parenthesis. We generate 1000 replications of the SVAR to compute the empirical standard errors. A.17

Table A5.2 FEVD under R2 : = 0 I;CA LR Investment Response to the World Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 97.29 95.43 99.87 99.86 99.99 99.30 (6.74) (11.72) (6.19) (9.26) (3.41) (6.91) 2 97.27 95.54 99.87 99.86 99.60 99.32 (6:75) (11:81) (6:19) (9:26) (3:72) (6:89) 4 97.26 95.44 99.87 99.86 99.38 99.32 (6:75) (11:89) (6:19) (9:26) (3:97) (6:90) 12 97.30 95.37 99.87 99.86 98.15 99.33 (6:69) (11:76) (6:19) (9:27) (4:20) (6:90) 24 97.32 95.33 99.87 99.86 99.07 99.33 (6:66) (11:58) (6:19) (9:27) (4:26) (6:90) Current Account Response to the Country-Speci¯c Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 93.80 59.47 78.97 92.84 73.58 82.01 (11.35) (23.06) (17.09) (15.67) (14.92) (16.31) 2 93.53 58.20 78.97 92.84 69.45 81.69 (11:74) (23:39) (17:09) (15:67) (16:81) (16:73) 4 93.66 58.38 78.97 92.84 68.54 81.47 (11:83) (23:42) (17:10) (15:68) (17:48) (17:20) 12 93.91 58.29 78.97 92.84 67.80 81.29 (11:90) (23:54) (17:10) (15:68) (17:90) (17:51) 24 93.99 58.30 78.97 92.84 67.56 81.24 (11:92) (23:50) (17:09) (15:69) (18:06) (17:62) In the top and bottom panels, small sample empirical standard errors appear in parenthesis. We generate 1000 replications of the SVAR to compute the empirical standard errors. A.18

Table A5.3 FEVD under R6 : = 1 CA;I LR ¡ Investment Response to the World Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 34.49 49.92 75.45 36.28 47.58 10.78 (17.18) (21.96) (18.83) (23.62) (20.99) (15.96) 2 35.59 49.96 75.45 36.29 68.06 63.56 (19:09) (22:33) (18:86) (23:59) (18:46) (25:19) 4 37.40 43.37 75.45 36.28 86.30 100.00 (22:84) (23:25) (18:50) (24:04) (16:91) (34:85) 12 51.52 49.15 75.45 36.26 95.96 100.00 (24:42) (21:98) (17:42) (25:50) (12:67) (36:02) 24 85.50 49.06 75.45 36.25 94.51 100.00 (22:61) (20:70) (16:40) (25:75) (11:06) (36:62) Current Account Response to the Country-Speci¯c Shock Forecast Horizon France Germany Italy Japan U.K. U.S. 0 4.38 9.30 26.42 16.09 31.07 00.04 (9.42) (14.89) (18.35) (19.62) (12.96) (8.12) 2 4.34 8.40 26.42 16.08 9.14 00.02 (9:36) (14:48) (18:35) (19:75) (11:78) (16:50) 4 5.15 8.57 26.41 16.06 6.61 0.00 (10:03) (14:80) (18:35) (20:02) (11:99) (23:32) 12 16.82 8.54 26.41 16.05 5.56 0.00 (14:34) (15:54) (18:35) (20:98) (12:42) (28:01) 24 6.02 8.54 26.41 16.05 5.52 0.00 (15:34) (15:63) (18:32) (21:04) (12:83) (28:51) In the top and bottom panels, small sample empirical standard errors appear in parenthesis. We generate 1000 replications of the SVAR to compute the empirical standard errors. A.19