The Terms of Trade, Investment and the Current Account

The Terms of Trade, Investment and the Current Account

This paper develops an optimizing model of a small open economy to study the adjustment of investment, saving, and the current account to a deterioration in the terms of trade. The analysis highlights the role of the real exchange rate as a channel through which changes in the terms of trade are transmitted to the rest of the economy. The results indicate that the response of investment and the current account to a permanent change in the terms of trade depends importantly on the relative strengths of income and substitution effects in determining household demand for non-traded goods. Furthermore, the paper finds that a temporary deterioration in the terms of trade is always associated with a current account deficit and capital accumulation in the long run, although the current account and investment may rise or fall in the short run.