The Role of Savings and Investment in Current Account Determination: The Case of the Federal Republic of Germany (1973 - 1979)

The Role of Savings and Investment in Current Account Determination: The Case of the Federal Republic of Germany (1973 - 1979) The paper contains a small disequilibrium macroeconomic model for Germany, which is intended to study the mechanism of adjustment of the German current account under flexible exchange rates. The model is also estimated on quarterly data from the first quarter of 1973 to the third quarter of 1979 using Wymer’s programs. The main hypothesis underlying the model is that German current account developments cannot be properly understood without reference to the behaviour of savings and investment, the ex post difference in which must be equal to the current account, if the government budget deficit is equal to zero. Thus the model departs from previous empirical work on the current account in that its focus is on the savings and investment functions rather than import and export demand functions. The main channels through which a depreciation of the exchange rate affects the current account that are considered in the model are (i) the real wealth effect on savings. The depreciation is assumed to increase the price level and this reduces the real value of wealth and hence savings. If the depreciation occurs at a time when the current account isin deficit, as has been the case in recent years, this effect tends to retard the adjustment of the current account. (ii) The real interest rate effect on savings. This effect is equilibrating if under the circumstances outlined above (depreciation occurring at a time of current account deficit) the real interest rate tends to increase as a result of balance of payments deficits and outflows of money from the country. (iii) The real interest rate effect on investment, which is also equilibrating under the above assumptions. (iv) The terms of trade effect on investment, which is assumed to affect investment positively. Hence, when the exchange rate depreciates, if import prices increase more rapidly than export pricesin domestic currency investment tends to fall and to contribute towards reabsorption of the current account deficit. | All these four channels are shown to have been empirically significant for Germany during the flexible exchange rate period. The model also contains demand functions for financial assets held by Germans abroad and by foreigners in Germany. They are relevant in order to endogenize the balance of payments and reserve flows, which are an important factor in interest rate determinatio