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Terms of Trade Shocks and the Non-Monotonic Adjustment of the Current Account

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  • Olivier Cardi

Abstract

This paper investigates both the dynamic and steady-state effects of anticipated permanent and temporary terms of trade shocks within a two-good small open economy with habit formation and capital adjustment costs. A permanent terms of trade worsening induces a deficit-surplus current account sequence if habits adjust faster than the physical capital. Following a temporary shock, the open country experiences a larger short-run current account deficit triggered by a greater decline in savings, followed by a surplus driven by a drop in investment. Numerical results show that the hump-shaped adjustment of real consumption can lead to overall welfare gains if habit persistence is strong enough, the shock is short-lived, and trade openness is not too high.

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  • Olivier Cardi, 2011. "Terms of Trade Shocks and the Non-Monotonic Adjustment of the Current Account," Annals of Economics and Statistics, GENES, issue 103-104, pages 195-221.
  • Handle: RePEc:adr:anecst:y:2011:i:103-104:p:195-221
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    1. Schubert, Stefan F & Turnovsky, Stephen J, 2002. "The Dynamics of Temporary Policies in a Small Open Economy," Review of International Economics, Wiley Blackwell, vol. 10(4), pages 604-622, November.
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