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Journal of Economic Integration 2005 December;20(4) :789-808.
Terms-of-Trade Shocks and the Current Account

Wai Mun ChiaJoseph D. Alba 

Nanyang Technological University
Copyright ©2005 Journal of Economic Integration

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 termsof- 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.

JEL Classifications: F32, F41

Keywords: Current account | Terms-of-trade | Imperfect competition | Nominal price rigidities | Harberger-Laursen-Metzler effect
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