Is the relationship between the current account balance and the terms of trade affected
by the persistence of terms of trade shocks? In intertemporal models of the current
account that incorporate a consumption-smoothing and an investment response to shocks,
the effect of the terms of trade on external balances is predicted to be dependent
on the duration of terms of trade shocks. Using a median-unbiased estimator, an unbiased
model-selection rule, and terms of trade data for 128 countries over the period 1960-99
we identify two groups of countries-those that typically experience temporary terms
of trade shocks and those that typically experience permanent terms of trade shocks.
The results from panel-data regressions of the two groups of countries support the
theoretical predictions of the intertemporal approach to the current account. We
find that the greater (lesser) the persistence of the terms of trade shock, the more
(less) the investment effect dominates the consumption-smoothing effect on saving,
so that the current account balance moves in the opposite (same) direction as that
of the shock.