Current Accounts in the Long and the Short Run

Faced with income fluctuations, countries smooth their consumption by raising (lowering) savings when income is high (low). How much of these savings do countries invest at home and abroad? In other words, what are the effects of fluctuations in savings on domestic investment and the current account? In the long run, we find that countries invest the marginal unit of savings in domestic and foreign assets in the same proportions as in their initial portfolio, so that the latter is remarkably stable. In the short run, we find that countries invest the marginal unit of savings mostly in foreign assets, and only gradually do they rebalance their portfolio back to its original composition. This means that countries try to smooth not only consumption, but also domestic investment. To achieve this, they use foreign assets as a buffer stock.