Current Account Dynamics and the Terms of Trade: Harberger-Laursen-Metzler Two Generations Later

Abstract

The current account dynamics is examined for a small open economy which is subject to exogenous changes in its static terms of trade and in world interest rates. The model used is one with overlapping finite-lived generations, which we argue gives rise to a more reasonable saving behaviour than previously used models with infinite lived consumers.In particular no restrictions on the rate of time preference is required.Anticipated and unanticipated, as well as temporary and permanent,terms of trade changes have very different effects. There is, however,a general tendency towards cycles in both savings and investment,which gives rise to cycles in the current account.The classic Harberger-Laursen-Metzler effect on saving of a terms of trade deterioration can have any sign for plausible parameter values,both for temporary and permanent disturbances.