Transitory Terms-of-Trade Shocks and the Current Account

The paper uses an intertemporal perfect-foresight optimizing model to analyze the effect of transitory terms-of-trade shocks on a small open . economy's current-account and utility time profiles. An adverse terms-of-trade shift known to be temporary induces the economy to run down its stock of external assets in the period before the terms of trade revert to their initial level. Subsequently, the assets consumed during this period are reaccumulated. The current-account response is due only in part to a desire to smooth out the future consumption stream. In addition, households know that the real value of any debt incurred while the terms of trade are unfavorable will be reduced sharply when the terms of trade improve. This opportunity for intertemporal price speculation causes the time path of instantaneous utility to be discontinuous,