Terms of Trade and the Current Account under Uncertainty

Abstract

This paper analyses the effect of stochastic terms of trade shocks on the current account of a small and open economy. Under uncertainty the distinctions between expected and unexpected, transitory and permanent shocks of the previous perfect foresight literature break down. It is shown that under terms of trade presenting stochastic structural changes, the rational consumer makes use of an error learning model to form his expectations on future relative prices. In this framework the consumer's optimal plan is derived for a two-good certainty equivalence utility function. Finally a simulation for the foreign debt profile in the aftermath of a terms of trade deterioration is performed.