Terms-of-Trade Shocks and the Current Account

Terms-of-Trade Shocks and the Current Account

We investigate the relationship between terms-of-trade shocks and the current account of a small open economy in the presence of imperfect competition and nominal price rigidities in the nontraded sector. We show that a temporary terms-of-trade improvement results in a current account surplus since the increase in consumption of traded goods is smaller than the magnitude of terms-of-trade shock. This result is consistent with the well-known Harberger-Laursen-Metzler effect. However, the effects of permanent term-of-trade shocks on current account depend mainly upon the intra- and intertemporal elasticities of substitution in consumption. When prices are perfectly flexible, permanent terms-of-trade shocks have no dynamic effects on the current account.