Deterioration of the Terms of Trade and Capital Accumulation: a Reexamination of the Laursen-Metzler Effect

33 Pages Posted: 11 Apr 2004 Last revised: 27 Aug 2022

See all articles by Partha Sen

Partha Sen

University of Delhi - School of Economics; National Bureau of Economic Research (NBER)

Stephen J. Turnovsky

University of Washington - Institute for Economic Research; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: June 1988

Abstract

This paper analyzes the effects of both a permanent and a temporary deterioration In the terms of trade on a small open economy. The model, based on intertemporal optimization, emphasizes the labor-leisure choice and the role of capital accumulation There are two main conclusions to be drawn from the analysis. The first 1s that in all cases the transitional dynamics depends critically upon the long-run response of the capital stock to the deterioration m the terms of trade. This has been shown to consist of a substitution effect, which is negative, together with an income effect, which is positive. Secondly, since the steady state equilibrium depends upon the initla1 conditions of the economy, a temporary shock, by altering these initial conditions for some later date when the shock ceases, leads to a permanent effect on the economy. In the case where the substitution effect dominates, a deterioration in the terms of trade leads to a short-run reduction in investment and a short-run current account surplus, contrary to the Laursen-Metzler effect. However, when the long-run income effect dominates, the deterioration m the terms of trade leads to a short-run investment boom, accompanied by a short-term current account deficit. The Laursen-Metzler effect prevails, although it is driven by investment, rather than by savings behavior.

Suggested Citation

Sen, Partha and Turnovsky, Stephen J., Deterioration of the Terms of Trade and Capital Accumulation: a Reexamination of the Laursen-Metzler Effect (June 1988). NBER Working Paper No. w2616, Available at SSRN: https://ssrn.com/abstract=428359

Partha Sen (Contact Author)

University of Delhi - School of Economics ( email )

110007 Delhi
India
+91 11 725 7159 (Phone)
+91 11 725 7159 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stephen J. Turnovsky

University of Washington - Institute for Economic Research ( email )

Seattle, WA 98195
United States
206-685-8028 (Phone)
206-543-5955 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany