Structural adjustment to a terms of trade disturbance: The role of relative prices

Abstract

This paper investigates the impact of a terms of trade disturbance on a small economy which responds gradually to changes in relative prices. The key intertemporal link is, as in Dornbusch (1983), between the price of nontraded goods, the real interest rate, savings and the current account. If the traded and nontraded goods are bad substitutes in consumption, then an improvement in the terms of trade leads to a transitory current-account surplus, and conversely. International capital mobility reduces the impact of a terms of trade disturbance on relative prices, and also reduces the speed with which the economy adjusts to the disturbance.