Are current accounts driven by cost competitiveness or asset prices? A synthetic model and an empirical test

Abstract

Abstract While current account imbalances have widened in recent decades, their causes are still debated. Trade-centred approaches highlight the role of cost competitiveness, in particular unit labour costs, and aggregate demand. In contrast, finance-centred approaches focus on gross financial flows, driven by expectations and the return on assets, that impact demand and the exchange rate. This article, first, builds a simple model of the current account that provides a synthesis between the two approaches. Unit labour costs impact the current account via the real exchange rate and income distribution, while financial inflows drive up asset prices, which leads to nominal appreciation and an increase in domestic demand. Second, we estimate a reduced form of this model for 28 OECD countries from 1972 to 2014, controlling for both trade- and finance-centred channels and a wide range of control variables. Our results indicate that finance-centred channels, via equity and residential property prices, drove current account divergence in the OECD, while unit labour costs were less important. They suggest that the effects of gross financial flows deserve more attention in theoretical and empirical models of the current account.