Terms of trade shocks and the non monotonic adjustment of the current account

This paper investigates both the dynamic and steady-state effects of unanticipated permanent and temporary terms of trade shocks within a two-good small open economy with habit formation and capital adjustment costs. A permanent terms of trade worsening induces a deficit-surplus current account sequence if habits adjust faster than the physical capital. Following a temporary shock, the open country experiences first a larger short-run current account deficit triggered by a greater decline in savings, followed by a surplus driven by the drop in investment. Numerical results show that the hump-shaped adjustment of real consumption can lead to overall welfare gains if habit persistence is strong enough, the shock is short-lived, and trade openness is not too high.