Terms of Trade and Current Account Dynamics: A Methodological Critique

Abstract

This paper suggests that the recent intertemporal studies concerning the implications of terms-of-trade deterioration on the current account of a small open economy, may suffer from significant methodological deficiencies. The study demonstrates that while the assumption of a small open economy represents a legitimate modeling simplification, the analysis of the impact of perturbation of the terms of trade on the current account of this small open economy is methodologically erroneous. In particular, the paper demonstrates that a given pattern of terms-of-trade deterioration may be associated with opposing evolutionary patterns of the current account of this small economy. This paper argues that the methodology employed by several influential intertemporal studies concerning the relationship between the terms of trade and the current account of a small economy suffers from critical deficiencies. It demonstrates that while the assumption of a small open economy confronting exogenously determined terms of trade represents a legitimate modeling simplification, the analysis of the impact of perturbations of this terms of trade on the small open economy and on its current account is methodologically erroneous. In particular, the paper demonstrates that a small economy may experience diametrically opposing evolutionary patterns of the current account in association with a given pattern of terms-of-trade deterioration. The paper suggests, therefore, that predictions based on this literature are in need of reassessment. These intertemporal studies of the relationship between the terms of trade and the current account of a small economy have been conducted under the simplifying assumption that perturbations in the terms of trade are exogenous and do not affect the world interest rate.2 This approach may reflect a valid simplification as long as the study is concerned with exportable goods whose prices are insignificant in the determination of the general price level in the world economy. However, if the focus of the analysis is a small country that exports a group of commodities such as agricultural goods or industrial goods, a change in the terms of trade for the small economy may reflect fundamental changes in the world relative prices that are