The Harberger–Laursen–Metzler effect under capital market imperfections

This paper re-examines the effects of a permanent terms-of-trade change on a dynamic small open economy facing an imperfect world capital market as studied in Obstfeld [1982. Aggregate spending and the terms of trade: is there a Laursen–Metzler effect? Quarterly Journal of Economics 97, 251–270], which assumes that the economy faces a downward-sloping bond curve. The novelty of the present paper is that a saddle-path stable steady state comes into existence under the assumption that households' subjective discount rate is a decreasing function of instantaneous utility. The Harberger–Laursen–Metzler (HLM) effect is shown to hold unambiguously, i.e., an unanticipated permanent terms-of-trade deterioration leads to an increase in aggregate expenditure and a current account deficit. This result is in stark contrast to those obtained in Obstfeld [1982. Aggregate spending and the terms of trade: is there a Laursen–Metzler effect? Quarterly Journal of Economics 97, 251–270] and many other studies in the literature.