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Imperfect Asset Substitutability and Current Account Dynamics

In this paper, we present a model of the current account. The model has two variants, one in which assets are perfectly substitutable in investors' portfolios, and another in which they are not. We examine the responses of these two variants of the model to standard shocks, and show that under imperfect substitutability, a valuation effect comes into play. We focus on the external accounts, and examine the role and strength of these valuation effects. Additionally, the imperfect substitutability case allows us to examine the model's response to an exogenous change in investors' portfolio preferences. The model in this paper provides a framework for understanding the experience of the dollar's real value and of the US current account over the last decade.