Abstract
This paper analyzes the effect of unanticipated changes in the terms of trade on consumption expenditures and the current account in a small open economy. Simple formulas are obtained for the covariances of changes in consumption expenditures, the current account and the expected current account with changes in the terms of trade. It is shown that, if investment is uncorrelated with the terms of trade, a necessary condition for unanticipated changes in the terms of trade to be correlated with changes in consumption expenditures and the expected current account is that the real expected return on foreign bonds differs from the real expected return on domestic bonds.
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