Our study is motivated by India's growing CA deficits in the post-global financial crisis period and the apparent close relationship between the size of the CA deficit and the risks associated with its financing. Thus, we refine the above constraint, as the results of the present value model may be sensitive to the above estimates. Ghosh (1995) derived a consumption smoothing model which allows for a joint test of intertemporal solvency and the assumption of perfect capital mobility.
They find that the model fit improves significantly as the agents' information set is expanded to include external shocks through movements in the world interest rate and exchange rate. Failure to reject the null hypothesis means evidence in favor of the present value model. The informal test includes a visual inspection of the actual and optimal CA series, the correlation coefficient, and testing the equality of their variances.
The left-hand side of the budget constraint in equation (17) can be interpreted as the GR. It is also important to note that kzt is not a prediction of the CA in the usual sense, but rather it captures the constraints imposed by the model. First, the empirical literature shows that the present value model, when tested using annual data, subverts the limitations of the model (Bergin and Sheffrin 2000).
Finally, the variables such as no, ca* and r* are deprecated, since we are only interested in the dynamic implications of the intertemporal model.
Empirical Results and Discussion 1 Benchmark model
To assign a value to β (impatience), we take the sample mean value of the US real interest rate and define 1/(1r) to be equal to 0.982, where r is the sample mean. We followed the method used by Gregorio et al. 1994) and used the Input-Output Transaction Tables published by the Ministry of Statistics and Program Implementation, Government of India. Therefore, the results of the unit root tests are consistent with the present value models.
Panel (a) presents the trace and maximum eigenvalue test statistics, while panel (b) presents the estimated consumption slope parameter, θ, of the cointegration relationship. The estimated coefficient shows that consumption in India is biased towards the present as θ < 1, which is consistent with CA deficits in India for most of the sample period. The insignificance of 1 and 2 means that Rt is not correlated with the lagged values of not and catsm.
Panel (b) of Table 5 reports the results of the orthogonality test and shows that the combined coefficients of the lagged variables jointly equal zero. The visual inspection shows that the optimal CA path follows the major turning points for most of the period, including the East Asian crisis of 1997 and the recent global financial crisis of 2008. The validity of the current value model is examined by testing if the actual value of the k-vector is statistically equal to the assumed value of the k-vector, i.e.
However, it is interesting to note that the variance of the optimal CA is higher (1.582) than that of the actual CA, and is statistical. Third, we test for sensitivity by allowing for an alternative value of intertemporal elasticity, γ, and see whether the intertemporal or intratemporal factors improve the performance of the model. We construct the optimal CA range as a linear combination of the weights calculated using the underlying parameters of the unrestricted VAR in nie, cat and rt.
Similarly, the higher correlation coefficient, i.e. 0.998 (part b, Table 8), also shows better co-movements of the actual and the optimal consumption smoothing CA in the case of an extended model. In case 2, we exclude the real exchange rate from the model and retain only the real world interest rate to check whether the intertemporal or intratemporal effect improves the model performance. The results reported in Table 8 (column 4) show that decreasing the value of γ (case 1) improves the model performance, as the Wald statistic decreased from 0.254 to 0.234.
Interestingly, in Case 2, the result shows that Wald statistic decreased, that is, to 0.019, this implies that the presence of intertemporal effect significantly improves the fit of the model. Finally, Table 9 also shows that extended model outperforms benchmark model in terms of the deviation of actual CA from optimal CA and further confirms the dominance of intertemporal effects over intratemporal effects.
Conclusion and further discussion
Thus, the policies aimed at further opening the capital account will allow agents to draw on information from the external sector to form their consumption decisions. Furthermore, the dominance of intertemporal effects implies that the interest rate can serve as a corrective mechanism to keep the CA solvent, since the interest differential drives the capital flows required for the financing of the deficit. From a theoretical perspective, the inclusion of the risk premium together with the interest rate differential could be a reasonable extension of the model.
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In panel b, we measure the value of θ, the consumption slope component, which is then removed from the actual CA to obtain the actual consumption smoothing CA component. Panel b runs a Granger causality test, the first implication of the benchmark model that can be tested to see if CA Granger causes subsequent changes in net output. Tests for a comparative consumption equalization model (a) Informal test of the model. b) Formal model testing.
The Wald statistic follows a 2 distribution and tells us whether the constraint tests implied by the model are satisfied or not. The Wald statistic follows a 2 distribution and tells us whether the constraint tests implied by the model are satisfied or not.
