Davies, Ronald B.

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Adaptive Learning with a Unit Root: An Application to the Current Account
(University of Oregon, Dept of Economics, 2006-07-31) Davies, Ronald B.; Shea, Paul, 1977-
This paper develops a simple two-country, two-good model of international trade and borrowing that suppresses all previous sources of current account dynamics. Under rational expectations, international debt follows a random walk. Under adaptive learning however, international debt behaves like either a stationary or an explosive process. Whether debt converges or diverges depends on the model’s exact specification and the specific learning algorithm that agents employ. When debt diverges, a financial crisis eventually occurs to ensure that the model’s transversality condition holds. Such a financial crisis causes an abrupt decrease in the debtor country’s consumption and utility.