capital mobility and the current strongaccountstrong.pdfVIP

Capital Mobility and the Current Account RENE LM. STULZ* FacuIt_y of Finance, Cokgt of Business, The Ohio State Univcrsi~, Columbus, OH 43-310, USA This paper analyzes the effect of unanticipated changes in the terms of trade on consumption expenditures and the current account in a small open economy. Simple formulas are obtained for the covariances of changes in consumption expenditures, the current account and the espected current account with changes in the terms of trade. It is shown that, if investment is uncorrelated with the terms of trade, a necessary condition for unanticipated changes in the terms of trade to be correlated with changes in consumption expenditures and the expected current account is that the real expected return on foreign bonds differs from the real expected return on domestic bonds. This paper uses an optimizing framework to study the effects on a small country’s consumption espenditures and current account of an unanticipated change in the terms of trade. It is assumed that there are no restrictions to capital mobility, that an asset whose return is perfectly correlated with the terms of trade exists and that households can hold foreign equities in their optimally selected portfol