Discussion Paper Series 2006-E-22

The Great Moderation and the US External Imbalance

Alessandra Fogli, Fabrizio Perri

The early 1980s marked the onset of two striking features of the current world macro-economy: the fall in US business cycles volatility (the great moderation) and the large and persistent US external imbalance. In this paper we argue that an external imbalance is a natural consequence of the great moderation. If a country experiences a fall in volatility greater than the one of its partners, its incentives to do precautionary savings fall and this results in a permanent deterioration of its external balance. In order to assess how much of the current US imbalance can be explained by this channel, we consider a standard two country business cycle model in which households are subject to business cycles shocks they cannot perfectly insure against. The model suggests that a fall in business cycle volatility like the one observed in the US can account for about 20% of the actual US external imbalance.

Keywords: Business Cycle Volatility; Precautionary Saving; Current Account; Net Foreign Asset Position

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2006 Bank of Japan All Rights Reserved.

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