Terms-of-trade shocks and optimal investment: another look at the Laursen-Metzler effect

Conventional analyses of the effect of terms-of-trade shocks provide a misl eading view of their impact on investment and the current account due to th e exclusion of capital goods imports from the analytical framework - a feat ure that is both arbitrary and unrealistic. This paper reexamines the conse quences of permanent and transitory changes in the terms of trade in a rati onal-expectations model of a small open economy with intertemporally optimi zing agents, and with trade in both consumption and capital goods. In the p aper's framework, the response to a permanent terms-of-trade improvement is unambiguous: the long-run capital stock, and thus investment, must rise, a nd the current account must deteriorate - exactly the opposite of the Laurs en-Metzler effect. In turn, a transitory improvement in the terms of trade raises saving, but has an uncertain effect on investment. Thus, the impact on the current account is generally ambiguous, and is shown to depend criti cally on three factors: the import content of investment, the duration of t he windfall, and the degree of intertemporal substitutability in both consu mption and investment. (C) 1999 Elsevier Science Ltd. All rights reserved.