A frequent topic of debate in open-economy macroeconomics is the response of the external balance to exogenous fluctuations in the terms of trade. The sharp fluctuations in relative prices of traded goods that followed the oil-price shocks of the past two decades, and the subsequent sharp fluctuations in world trade, emphasized the importance of this issue and served to stimulate new research. Innovative theoretical models analyzed the relationship between terms of trade and the trade balance from a perspective based on intertemporal optimization and provided new insights into the nature of the optimal policy response to fluctuations in the terms of trade. The purpose of this paper is to provide some evidence of the empirical significance of some of these models.
The classic work of Harberger (1950) and Laursen and Metzler (1950) argued that the trade balance worsens in response to adverse developments in the terms of trade because the latter induce a decline in real income and savings—measured in terms of the international purchasing power of a country’s exports. They viewed the decline in savings, which, in the absence of investment, is equivalent to a worsening of the balance of trade, as an implication of Keynes’ proposition that the marginal propensities to save and consume are less than unitary. Their policy recommendation was, therefore, that policies aimed at inducing an improvement in the terms of trade would result in a strengthening of the balance of trade. In the early 1980s, the Harberger-Laursen-Metzler effect was questioned by Obstfeld (1982) and Svensson and Razin (1983), who argued that, because the motive behind the less-than-unitary marginal propensity to save is the individual’s desire to smooth consumption, the Harberger-Laursen-Metzler effect should be explored in a framework of explicit dynamic optimization. In such a framework, the response of the balance of trade to changes in the terms of trade depends on the public’s perception regarding the persistence of fluctuations in the terms of trade. In general, if individuals expect a decline in the terms of trade to be purely transitory, the Harberger-Laursen-Metzler effect follows; if they expect it to be permanent, the effect on the trade balance is smaller and, under certain conditions, can be neutral. Hence, policies aimed at improving a country’s terms of trade do not necessarily improve its trade balance.
This paper examines an intertemporal equilibrium model of a small open barter economy that is subject to random shocks affecting endowments, the terms of trade, and the real interest rate. Equilibrium stochastic processes for macroeconomic aggregates are computed, and their properties are compared with observed stylized facts. The model mimics the Harberger-Laursen-Metzler effect but cannot account for a countercyclical trade balance, the variability of the real exchange rate, and the income elasticity of imports.