Current Account, Exchange Rate, and Monetary Dynamics in a Stochastic Equilibrium Model

We construct a simple stochastic open-economy macro-economic model from the decision rules of rational optimizing agents, solving explicitly for the relationship between the model’s deep parameters, and the variance-covariance matrix of equilibrium returns on domestic and foreign assets. We use the model to study the dynamic relationship between exchange rate changes and current account flows in response to domestic monetary shocks, to establish the conditions under which exchange rate depreciations accompany current account deficits, and to investigate the link between time preference, risk aversion, and the dynamic exchange rate and current account response to monetary disturbances. The model generates current account time series which exhibit persistent deviations from balance, even for the special case in which domestic and foreign shocks are purely transitory.