Trade
It Depends

What effect does a change in the terms of trade have on the current account of the balance of payments? The large terms of trade shifts during the last decade have led economists to reappraise previous analyses in the light of modern theories of consumer behaviour, which emphasize the role of wealth in smoothing expenditure over time. CEPR Research Fellow Charles Bean reviews and extends this work in Discussion Paper No. 22.

It was previously argued that a terms of trade deterioration implied a fall in the real income of consumers, a reduction in savings and therefore, a worsening of the current account. Matters are less clear cut, however, if the terms of trade deterioration is regarded as permanent since although real income falls, there is then no reason for the pattern of savings to change. As Bean notes, more recent analyses have demonstrated that the effect on the current account is complicated. It depends on whether changes in wealth lead to changes in consumption spread uniformly over the consumer's lifetime or whether they are concentrated in particular periods. In other words, it depends on their degree of time preference or 'impatience'. Suppose consumers tend to become more 'impatient' as wealth falls. Then a deterioration in the terms of trade decreases real income, increases impatience and causes a shift in consumption from future periods to the present. Thus the current account deteriorates.

Bean extends this recent work to allow output to vary as well. Suppose the terms of trade deteriorate from an initial position of equilibrium, and this deterioration is viewed as permanent. This makes production less profitable than before, leading to a fall in output and a decline in employment and wages. What is the effect on the current account? This depends not only on the way the consumers' rate of time preference changes, but also on the relative ease of substitution of consumption and leisure between different time periods. If consumption can be switched easily between different time periods, then a terms of trade deterioration will also tend to lead to a deterioration in the current account. Conversely, if workers can easily be persuaded to work longer hours now in return for more leisure in the future, this makes more probable the opposite result, an improvement in the current account. In effect, a permanent terms of trade deterioration leads to a current account deficit if wealth effects are stronger on consumption than they are on labour supply. A decreasing rate of time preference alone is neither necessary nor sufficient for a permanent terms of trade deterioration to lead to a current account deficit.

Bean, like earlier authors, uses a model with two periods - 'the present' and 'the future' to derive these conclusions. Do they depend on the two-period simplification? Bean explores this question using a more complex multi-period model with overlapping generations. Even though each individual has only a finite lifetime, the labour market interaction between individuals of different generations leads to very complicated behaviour in the current account. A temporary shift in the terms of trade has effects on the current account long after those individuals who experienced it have died, and the adjustment to permanent changes is only gradual. Bean notes that abandoning the assumption of an initial equilibrium would further complicate matters by introducing wealth revaluation effects caused by the change in the terms of trade.

Although abstract, Bean's analysis confirms the view that the response of the current account to terms of trade shifts is likely to be very complicated and depends critically on whether such changes are seen as temporary or permanent, and whether they are anticipated or unanticipated. In particular, there may be a current account improvement in advance of an anticipated future deterioration in the terms of trade. In general, there seems to be little presumption in practice that it will either improve or deteriorate.


The Terms of Trade, Labour Supply and the Current Account
Charles R Bean

Discussion Paper No. 22 June 1984 (IM)