Arman Mansoorian, Ph.D., Economics, York University, 4700 Keele Street, North York, ON M3J 1P3, Canada and Mohammed Mohsin, Ph.D., Economics, University of Tennessee, Knoxville, Knoxville, TN TN 37996.
The recent experiences of several countries that have undertaken trade liberalizations indicate that such policies lead to a non-monotonic adjustment of the current account. Dornbusch (J. Econ. Perspectives, 1992) states “the elimination of obstacles to trade invariably creates an immediate increase in imports. But ... the beneficial rise in exports does not happen immediately’’ (pp. 81–82).
We propose that a small open economy model with an endogenous time preference (Uzawa (1968) and
Obstfeld (1982, Quarterly J. Econ.)) in which consumption exhibits durability is capable of generating current account dynamics that is consistent with the experiences of several countries after their trade liberalization policies.
The assumption that consumption goods exhibit a certain degree of durability is realistic. Durable goods constitute about eighteen percent of total consumption expenditures in U.S.; see, e.g., Obstfeld and Rogoff (1996, Foundations of International Macroeconomics, p. 96).
The assumption of endogenous time preference has been used in a small open economy setting by several authors; see, e.g., Obstfeld (1981a, b), Mendoza (1991, A.E.R.), and Devereux and Shi (1991, J.I.E.). This assumption is useful in a small open economy setting because the small open economy faces a fixed rate of interest, which must be equal to the rate of time preference in the steady state. Hence, if the rate of time preference is also fixed, for a steady state to exist, it must be set equal to the rate of interest. This precludes interesting dynamics; see, e.g., Obstfeld for a complete discussion.
With an endogenous time preference, there is a unique level of instantaneous utility that must be maintained in the steady state. This level of utility is given by the condition that in the steady state the rate of time preference must be equal to the world interest rate. A trade liberalization, be removing trade distortions, increases welfare. As a result, the steady state equality of the rate of time preference to the world interest rate implies that the country must reduce its net foreign assets in the steady state. This “time preference effect” tends to lead to an increase in consumption expenditures and a current account deficit after the trade liberalization.
On the other hand, if consumption exhibits durability the increase in consumption expenditures that follows the trade liberalization tends to increase the stock of durables. As the stock of durables increases above its steady state level, it requires that somewhere along the adjustment path there be a decrease in consumption expenditures below their steady state levels, in order to run down the stock. This “durability effect” tends to turn the current account into a surplus. Hence, the “time preference effect” followed by the “durability effect” gives rise to the adjustment of the current account that is consistent with the experiences of several countries following their trade liberalizations.