Flexible exchange rates and current account adjustment

Current account imbalances should in theory be corrected by real exchange rate adjustments that stimulate exports and deter imports. Since pegging the exchange rate may inhibit real exchange rate adjustment, the correction of current account imbalances is likely to be slower when the exchange rate is less flexible. We re-investigate the puzzle that cross-country data lend little empirical support to this proposition. The current account can be disaggregated into the trade balance, which is likely to bear the burden of adjustment, and the other components (net property income and transfers), whose response to real exchange rate movements is complex. If we confine our attention to the trade balance, the puzzle disappears: unlike the current account balance, the trade balance is significantly less persistent when the exchange rate is more flexible. The trade balance responds only weakly, however, to the non-trade component of the current account. Estimation by robust regression suggests that the current account persistence puzzle is essentially a problem of distortion of the results by outliers. Under flexible exchange rates, real exchange rates respond in the expected direction to current account imbalances, and larger real exchange rate movements induce bigger corrections in the current account.