The Harberger-Laursen-Metzler Effect Revisited: An Indirect-Utility-Function Approach

To study the effect of a terms-of-trade shock on the current account, Ostry and Reinhart (1992) and Cashin and McDermott (1998) estimate the intertemporal and intratemporal elasticities of substitution, for a set of countries, constructing importable and non-tradable consumption series. Unfortunately,these series are not available for most developing countries. This paper presents a dynamic stochastic framework, similar to Ostry and Reinhart’s, that maximizes a representative agent’s indirect utility function. The Euler conditions derived from the optimization problem do not depend on variables such as tradable and non-tradable consumption, avoiding the need for constructing them and adopting strong assumptions. Using GMM and Chilean quarterly data for the 1986-2002 period, I conclude that moderately low intertemporal and intratemporal substitution effects exist. The first estimated elasticity lies in the range of 0.46 to 0.56 and the latter is around 1.