Terms-of-trade shocks and optimal investment: another look at the Laursen-Metzler effect

Abstract

Conventional analyses of the effect of terms-of-trade shocks provide a misleading view of their impact on investment and the current account due to the exclusion of capital goods imports from the analytical framework — a feature that is both arbitrary and unrealistic. This paper reexamines the consequences of permanent and transitory changes in the terms of trade in a rational-expectations model of a small open economy with intertemporally optimizing agents, and with trade in both consumption and capital goods. In the paper's framework, the response to a permanent terms-of-trade improvement is unambiguous: the long-run capital stock, and thus investment, must rise, and the current account must deteriorate — exactly the opposite of the Laursen-Metzler effect. In turn, a transitory improvement in the terms of trade raises saving, but has an uncertain effect on investment. Thus, the impact on the current account is generally ambiguous, and is shown to depend critically on three factors: the import content of investment, the duration of the windfall, and the degree of intertemporal substitutability in both consumption and investment.