Current Account Dynamics with Rule of Thumb Consumers

In this paper the idea that some households always spend the totality of their current income the rule of thumb behavior is applied to a small open economy framework. A model of current account with rule of thumb individuals and habit formation is constructed and estimated for five different countries. Two parameters of the model are of particular interest: the share of domestic income that accrues to rule of thumb individuals and the coefficient of habit formation. Using current account data, the results obtained here provide strong support for the view that rule of thumb behavior plays a major role in the economy, in contradiction with the Permanent Income Hypothesis. Moreover, the estimated habit formation coefficients are mostly small and nonsignificant. These findings pose a challenge to previous studies that conclude that habit formation is the key element that renders a negligible role to rule of thumb behavior. Area-SBE: Macroeconomia Aplicada