Current Account Adjustments, Exchange Rates and Extensive Margin

Kanda Naknoi

Purdue University

October 2008

Abstract

Dynamic adjustments of current account imbalances require real exchange rate appreciations. This study adds the industry composition of trade as an additional adjustment margin in a dynamic stochastic general equilibrium model with real and nominal rigidities. We use the model to evaluate the adjustments of the U.S. current account deficit. We find that the real exchange rate must depreciate by 15 percent. Consumption drops almost as much as the deficit. Investment plays a small role due to large installation costs of capital. The range of export gradually expands by 10 percent, and it takes 10 years to complete the adjustments.