DP6010 | The 'Great Moderation' and the US External Imbalance

Publication Date

17/12/2006

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Abstract

The early 1980s marked the onset of two striking features of the current world macro-economy: the fall in US business cycle 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 that of its partners, its relative incentives to accumulate precautionary savings fall and this results in an equilibrium permanent deterioration of its external balance. 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 country specific shocks they cannot perfectly insure against. The model suggests that a fall in business cycle volatility like the one observed for the US relatively to other major economies can account for about 20% of the current total US external imbalance.