Terms-of-Trade Shock and the Current Account in a Monetary Economy

Abstract

Over the period 1973-81, the terms of trade of non-oil developing countries deteriorated at about 2 per cent per annum. This was accompanied by an increase in current account deficits in excess of 3 per cent above what they had been in the previous decade. (See Khan and Knight, 1983, for a discussion; these authors find the terms-of-trade shocks the major cause of the deficits.) This has led to a renewal of interest in the effects of changes in terms of trade for a small open economy. The conventional wisdom, first put forward by Laursen and Metzler (1950) and Harberger (1950), emphasized the fact that a terms-of-trade worsening lowered real income, which in turn lowered savings and worsened the current account-the Laursen-Metzler Effect. The recent reappraisal was initiated by Obstfeld (1982). He showed, in an infinite-horizon-optimizing framework with perfect capital mobilizing, that if the discount rate was a function of the level of utility, surpluses, and not deficits, accompany an unanticipated and permanent terms-of-trade worsening. The long-run level of the discount rate is tied down by the given world rate of interest. This in turn fixes the long-run level of utility. The terms-of-trade shock tends to lower the level of utility and agents save to offset this. Across steady states there is only a substitution effect. On the other hand, if the discount rate is fixed and equal to the world interest rate, then the economy adjusts to the terms-of-trade shock by immediately lowering real expenditure by the same amount as the decline in real income so that the current account is always balanced. Svensson and Razin (1983) showed that in a two-period framework this does not necessarily happen. For the infinite-horizon case they showed that, if preferences were separable over time and the discount rate was increasing in instantaneous utility, then Obstfeld's results were indeed obtained. In a two-period overlapping-generations model, the results could be modified owing to the fact that human wealth and non-human wealth are not perfect substitutes and a terms-of-trade shock affects these differently. (See Matsuyama, 1988, for a discussion.) But it is still true that an unanticipated permanent terms-of-trade shock has a one-shot effect on the current account unless some ad hoc costs of adjustment are introduced (see e.g. Persson and Svensson, 1985, and Matsuyama, 1988). The uncertain lifetime model (see e.g. Frenkel and Razin, 1988, and Matsuyama, 1987) generates non-trivial