THE OIL PRICE increases of 1973–74 and 1979–80 brought about an extensive literature dealing with the response of the current account to supply shocks in the context of intertemporal optimizing real models. In one of the more influential papers on this subject, Sachs (1981) develops a two-period model of an economy producing, consuming, investing, and exporting a final good and importing an intermediary input, oil. A temporary oil price increase induces a current account deficit because of the desire of the household to smooth out consumption over time. In contrast, a permanent oil shock generates a surplus in the current account. This key result follows from the fact that there is no change in saving while investment falls.1
Empirical evidence for oil-importing countries, particularly developing countries, indicates, however, that current account deficits persisted throughout the 1970s and into the 1980s.2 In contrasting the predictions of the model with the empirical evidence, Sachs (1981) argues that since the first oil shock turned out to be permanent, it seems reasonable to assume that in general people anticipated this, thus invalidating as an explanation for the observed current account deficits the argument that economic agents perceived the shock as temporary. Hence, one has to rely on alternative explanations, such as the effects induced by a fall in the world real rate of interest, to generate the possibility of a deficit. Marion and Svensson (1984b) show that the world real interest rate will fall following a permanent rise in oil prices if it is assumed that the marginal propensity of the Organization of Petroleum Exporting Countries (OPEC) to consume is less than that of the rest of the world. If the resulting increase in absorption in oil-importing countries dominates the drop in gross domestic product (GDP), a deficit will arise. When non-traded goods are introduced into the picture, however, Marion (1984) indicates that the direction of the change in the current account following a permanent oil shock depends critically on the relative production technologies in the traded and nontraded goods sectors.3
The constancy of the rate of time preference, which is assumed in all of these models, plays an important role, as suggested by Svensson and Razin (1983). They develop a many-good, two-period model, with no investment, to study the Harberger-Laursen-Metzler (hereafter H-L-M) effect. They show that, given identically homothetically weakly separable preferences, a rate of time preference that is an increasing function of the welfare level, as in Obstfeld (1980, 1982), implies that the current account improves following a terms of trade deterioration.
In contrast, the response of the current account in the context of optimizing monetary models with flexible exchange rates and investment seems to have received less attention. The difficulties encountered by real models in accounting for observed deficits in oil-importing countries suggest that this may be a fruitful line of research insofar as it could point to additional—that is, monetary—channels through which an oil shock could affect a small open economy.
The presence of money in itself, however, does not alter the picture. Fender and Nandakumar (1985) develop a two-period, two-good, Sidrausky-type model to study fiscal policy, the “Dutch disease,” and the effects of oil shocks. They find that a future increase in oil prices could, under some circumstances, generate a current account deficit. From this it follows that a permanent oil shock could also result in a deficit. But this outcome seems to derive from the presence of nontraded goods, along the lines suggested by Marion (1984). In fact, it is simple to show that if money enters separably into the utility function, money is only a “veil” in that the results of standard real models—for instance, Svensson (1984)—are reproduced (Vegh (1987a)). Clearly, this outcome is to be expected, since changes in the stock of real money that result from changes in wealth are brought about by movements in the exchange rate.
This paper shows that allowing for currency substitution substantially affects the results of real or domestic-money-only models. In the presence of currency substitution,4 a permanent oil shock could result in a current account deficit. Furthermore, the greater the economy’s dependence on oil—as measured by the level of pre-shock oil imports—the larger the deficit.5 In real models, the change in the current account does not depend on the initial level of oil imports because consumption drops by the same amount that real income does, thus leaving saving unaffected.6 When there is currency substitution, however, the possibility of a decrease in saving arises, which is financed by running down the stock of foreign money balances. This H-L-M effect depends on the magnitude of the fall in wealth, which in turn is dictated by the initial level of oil imports. The larger the decrease in saving, the more likely that it will offset the fall in investment, thus generating a current account deficit.
If the sign of the change in the current account is left aside, real models can also be interpreted as suggesting that, following a permanent oil shock, variations in investment dominate current account movements. As Fischer (1981) points out, however, the evidence does not bear out this prediction. Fischer (1981) shows that the mean absolute changes in the ratio of saving to GNP have been larger than those in the ratio of investment to GNP for both OECD and developing countries. Hence, an attractive feature of the currency substitution model is that it generates movements in both saving and investment.
The proposition that a terms of trade deterioration leads to a worsening of the current account finds empirical support in Khan and Knight (1983). They provide a formal analysis of the influence of external and internal factors on the current account of non-oil developing countries. Using pooled time-series cross-section data for a sample of 32 countries during 1973–80, they report, among other findings, that the effect of a change in the terms of trade on the current account is positive and statistically significant. More precisely, a 1 percent deterioration in the terms of trade would lead, on average, to a decline of about half a percentage point in the ratio of the current account to exports. Furthermore, changes in the terms of trade turn out to be the most important of the six explanatory variables considered.7
This paper proceeds as follows. Section 1 presents a two-period model of currency substitution. The inclusion of both currencies, which are the only assets, in the utility function is meant to capture the services that money provides other than being a store of value.8 This framework has been used by, among others, Calvo (1980, 1985) and Liviatan (1981). The implicit assumption is that, because of legal restrictions, domestic and foreign money are not perfect substitutes. A condition for the current account to deteriorate following a permanent oil shock is derived from the model. A high level of pre-shock oil imports ensures that this condition holds. In addition, the higher the initial level of oil imports, the larger the current account deficit. Section II, building upon an insight developed in the previous section, presents a study of a fixed-exchange-rate model and concludes that it reproduces the relevant results, even if the household no longer cares about foreign money, because, under fixed rates, domestic money acts as if it were foreign money. The possibility that, under fixed exchange rates, a deterioration in the terms of trade could lead to a deficit has already been pointed out by Michener (1984), in the context of an optimizing version of models of the monetary approach to the balance of payments. The much simpler model of this section isolates this effect and makes the point that, under a constant path of the fixed exchange rate, the workings of the currency substitution model and the fixed rates model are identical. Section III contains some concluding remarks.
Calvo, Guillermo, “Apertura financiera, paridad móvil, y tipo de cambio real,” Documentos de Trabajo 21 (Buenos Aires: Centro de Estudios Macro-ecónomicos de Argentina, November 1980).
Calvo, Guillermo, “Currency Substitution and the Real Exchange Rate: The Utility Maximization Approach,” Journal of International Money and Finance (Guildford, England), Vol. 4 (June 1985), pp. 175–88.
El-Erian, Mohamed, “Currency Substitution in Egypt and the Yemen Arab Republic,” Staff Papers, International Monetary Fund (Washington), Vol. 35 (March 1988), pp. 85–103.
Fender, John, and Parameswar Nandakumar, “An Intertemporal Macroeconomic Model with Oil and Fiscal Policy,” Seminar Paper Series, No. 313 (Stockholm: University of Stockholm, Institute for International Economic Studies, February 1985).
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Khan, Mohsin S., and Malcolm D. Knight, “Determinants of Current Account Balances of Non-Oil Developing Countries in the 1970s: An Empirical Analysis,” Staff Papers, International Monetary Fund (Washington), Vol. 30 (December 1983), pp. 819–42.
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Marion, Nancy, “Nontraded Goods, Oil Price Increases and the Current Account,” Journal of International Economics (Amsterdam), Vol. 16 (February 1984). pp. 29–44.
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Marion, Nancy, and Lars Svensson (1984b), “World Equilibrium with Oil Price Increases: An Intertemporal Analysis,” Oxford Economic Papers (Oxford), Vol. 36 (March), pp. 15–21.
Michener, Ron. “A Neoclassical Model of the Balance of Payments,” Review of Economic Studies (Avon, England), Vol. 51 (October 1984), pp. 651–64.
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Mr. Vegh, an economist in the European Department, was an economist in the Research Department when this paper was written. He holds a doctorate from the University of Chicago.
This paper is based in part on the author’s doctoral dissertation at the University of Chicago. The author would like to thank the members of his thesis committee, Joshua Aizenman, Jacob Frenkel, and John Huizinga, as well as Guillermo Calvo, Pablo Guidotti, Lars Svensson, and colleagues in the Fund for helpful comments and suggestions.
Oil and capital are assumed to be complements, in the sense that their cross derivative is positive. This assumption is supported by econometric evidence as pointed out by Sachs (1981).
Ostry (1988; in this issue of Staff Papers) also notes that the presence of nontraded goods causes an ambiguous response of the current account to a permanent deterioration in the terms of trade.
Sachs (1981) reports that as far as oil-importing countries are concerned, the change in the current account relative to gross national product (GNP) is negatively correlated with the pre-shock ratio of oil imports to GNP—the correlation coefficient being -0.7—for the period 1968–79. Sachs (1981) also finds that for oil-importing members of the Organization for Economic Cooperation and Development (OECD), a 1 percentage point greater dependence on oil in 1968–73 corresponds to a drop in the ratio of the current account to GNP of 0.9 percentage points in 1974–79. Sachs (1981) claims that these results come primarily from the first years after the shock.
The effect of the initial level of oil imports on the partial derivative of the investment function, which is ambiguous, is disregarded.
As measured by the relevant Beta coefficients. The other explanatory variables are the rate of growth of industrial countries, the level of foreign real interest rates, the change in real effective exchange rates, the ratio of domestic fiscal deficits to GDP, and a time trend.
This setup has been adopted for simplicity. The basic results would not change if bonds were allowed for and both monies were viewed as reducing transaction costs, as in Vegh (1987b), because, for the issues being discussed in this paper, the key ingredient is that money be valued and not why it is valued. When dealing with issues such as the optimal inflation tax, however, the question of why money is valued plays a critical role in determining the outcome of the analysis. Hence, it becomes essential that the analysis be explicit on this point (see Vegh (1987b) for a discussion).
The foreign price level is assumed to be constant.
The logarithmic specification of the utility function is adopted because it simplifies the algebraic manipulations. A general formulation, however, would lead to similar results.
For simplicity, the level of initial oil imports is being treated as a parameter whose value does not affect the initial equilibrium. The implicit experiment one has in mind is that of a change in technology such that, at the initial oil price, the input composition is altered, but the aggregate levels of production and investment remain unchanged. Under these circumstances, the coefficients A, B, and C do not vary with z. Note that it is not necessary that the new technology generates the same investment function but that, at the initial oil price, the level and slope be the same, which also ensures that iq does not vary with z.
The coefficient of ? is taken to be positive. Note that equal weights in the utility function are a sufficient, though not necessary, condition to ensure this result.
In real models, Svensson (1984) makes the point that if oil is consumed directly (heat or gasoline), the effect on the current account of a permanent oil shock becomes ambiguous owing to substitution effects in consumption.
Since one can view the stock of foreign money as being equivalent to a stock of a durable tradable good, the present analysis suggests that a real model with a durable consumption good could generate similar implications concerning the response of the current account to a permanent oil price increase. (I am indebted to Guillermo Calvo for this point.)