Anticipated foreign military threat, arms accumulation, and the current account in a small open economy

Abstract

This paper examines the effects of an anticipated foreign military threat on consumption, the home weapons stock, and net foreign asset position in a small open economy. If the utility function is separable between butter and guns, the economy decreases both butter and guns when the news arrives, accumulates foreign assets prior to the foreign threat realization, and increases guns as the foreign threat realizes. If the utility function is nonseparable between butter and guns, the economy may have two dynamic responses. The first is similar to the separable case, except that consumption exhibits a discrete jump when the foreign threat realizes. The second is that the economy increases both butter and guns on impact, decumulates foreign assets prior to the foreign threat implementation, but either increases or decreases guns as the foreign threat realizes.