Deterioration of the terms of trade and capital accumulation: A re-examination of the Laursen-Metzler effect

Abstract

This paper analyzes the effect of both a permanent and a temporary deterioration in the terms of trade on a small open economy. The model, based on intertemporal optimization, emphasizes the labor-leisure choice and the role of capital accumulation. The transitional dynamics is shown to depend upon the long-run response of the capital stock to the terms of trade shock. This consists of a negative substitution effect, together with a positive income effect. Whether or not the Laursen-Metzler effect holds depends upon whether the income effect dominates the substitution effect.