A Dissection of the Current Account Persistence Puzzle

Chinn and Wei (2013) show that the ratio of the current account balance to GDP is as persistent under floating rates as under pegged rates. This result contradicts economists’ widely held belief that current account imbalances should be corrected more quickly under floating. This belief consists of three elements: (a) imbalances will induce corrective real exchange rate movements; (b) real exchange rates move further under floating; and (c) larger real exchange rate movements will induce bigger shifts in the current account balance. It is shown that the data support (b) and (c) but not (a): the real effective exchange rate does not respond significantly to the current account balance. The results are robust to the choice of regime classification scheme, time variation of equilibrium values using a Hodrick-Prescott filter, and to recent regime switches. The implication is that the failure of real exchange rates to react as expected to current account imbalances is the main source of the puzzle.