Habit Formation, the World Real Interest Rate, and the Present Value Model of the Current Account

A recent study reports that habit formation in consumption can improve the ability of the present value model of the current account (PVM) to forecast actual current account movements because habits make the current account more volatile. This paper, however, shows that the habit-forming PVM is observationally equivalent to the canonical PVM augmented with a transitory consumption shock: the sample test statistics of the habit-forming PVM are not informative to detect the role of habit formation in current account movements. This identification problem is resolved by conducting Monte Carlo experiments of two small open economy-real business cycle (SOE-RBC) models calibrated to Canadian postwar quarterly data: one with habit formation and the other with the stochastic world real interest rate. Results reveal that the SOE-RBC model with the stochastic world real interest rate dominates the SOE-RBC model with habit formation in explaining Canadian sample test statistics of the habit-forming PVM as well as the standard PVMs. This suggests that research on the current account should concentrate on the determinants of the world real interest rate rather than alternative specifications of utility.