Intertemporal Price Speculation and the Optimal Current-Account Deficit

The paper studies the effects of terms-of-trade fluctuations in an infinite-horizon optimizing model of a small open economy. While the current-account response to a transitory terms-of-trade shock is in part explicable by intertemporal smoothing, an important additional factor is the effect of anticipated future terms-of-trade shifts on the real value of the external debt in terms of the home consumption basket. When foreign borrowing is indexed to the import good, a temporary worsening of the terms of trade creates the expectation of a decline in the real value of external debt. This fall in the relevant real interest rate leads households to increase consumption while export prices are low and to decrease consumption sharply once the terms of trade recover. If an adverse price shock is of sufficiently brief duration, instantaneous utility will rise initially.