Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs,

s, and the CA

Slides for Chapter 4: Terms of Trade, the World

Interest Rate, Tariffs, and the Current Account

Columbia University

September 6, 2022

These are the slides for the textbook, “International Macroeconomics: A Modern Approach,” by
Stephanie Schmitt-Grohé, Martı́n Uribe, and Michael Woodford, Princeton University Press, 2022,
ISBN: 9780691170640.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Motivation

Thus far, we have studied the adjustment to endowment shocks.

Other important shocks for open economies are shocks to

• the terms of trade

• the world interest rate

• tariffs

What happens with consumption, the trade balance, and the current
account in response to these shocks?

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Terms-of-Trade Shocks

Thus far, we have studied an economy with a single good. House-

holds consume and are endowed with, say, bananas. Sometimes the
country exports bananas and sometimes it imports bananas.

However, the goods countries export may be different from the

goods the country imports. Some oil producing countries, for exam-
ple, export mostly oil and import consumption goods such as food,
electronics, and automobiles.

Let’s make the model more realistic and study an economy in which
households like to consume a good different from the good they are
endowed with.

The relative price of exports in terms of imports is known as the

terms of trade.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The Terms of Trade

Let P1X and P1M be the prices of exports and imports in period 1.

The terms of trade in period 1, denoted T T1, is

P1X
T T1 ≡ .
P1M

Continuing with the example of an oil exporter, if the price of oil

is $90 per barrel and the price of wheat is $10 per bushel, then
P1X = 90, P1M = 10, and the terms of trade is 9, or T T1 = 9. Here,
T T1 represents the price of oil in terms of wheat and indicates the
amount of wheat that the country can afford to import if it exports
one barrel of oil. Put differently, T T1 = 9 means that with one barrel
of oil the country can buy 9 bushels of wheat.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The Intertemporal Budget Constraint

The budget constraint in period 1 is

C1 + B1 − B0 = r0B0 + T T1Q1.

The budget constraint in period 2 is

C2 + B2 − B1 = r1B1 + T T2Q2.

Using the transversality condition B2 = 0 and combining the two

budget constraints to eliminate B1, yields the intertemporal budget
constraint
C2 T T2Q2
C1 + = (1 + r0)B0 + T T1Q1 + .
1 + r1 1 + r1
Note that it is identical to its counterpart in the one-good economy,
except that here we have T T1Q1 and T T2 Q2 instead of Q1 and Q2.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Effects of Terms-of-Trade Shocks

We just deduced that terms-of-trade shocks are just like output

shocks. If income in period 1, T T1 Q1, goes up, the household doesn’t
care whether this is due to an increase in T T1 or Q1.

Consequently, the adjustment to terms of trade shocks is identical

to the adjustment to endowment shocks:

The country finances temporary changes in the terms of trade by

changing the current account (upwardly if the shock is positive and
downwardly if it is negative), to smooth consumption over time.

The country adjusts to permanent terms-of-trade shocks by mostly

changing consumption (upwardly if the shock is positive and down-
wardly if it is negative), with little movement in the current account.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Terms-of-Trade Shocks and Imperfect Information

When a shock hits the economy, it is not easy to tell whether it is

permanent or temporary.

Agents must form expectations about the duration of the shock,

which may or may not be validated by future developments.

When expectations are not fulfilled, the behavior of the economy

may ex-post look at odds with the prediction of the intertemporal
theory of current account determination.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Suppose that initially T T1 = T T2 = T T and Q1 = Q2 = Q. Suppose

now that in period 1 the terms of trade appreciate by ∆ > 0 in
period 1 and by 2 × ∆ in period 2.

How does the current account adjust to this development?

If households expect the improvement in period 1 to be transitory

(T T2 = T T ), then the current account in period 1 will improve,
CA1 ↑.

But if households correctly anticipate that the future terms of trade

will be even better by rising to T T + 2 × ∆ in period 2, then the
current account in period 1 will deteriorate, CA1 ↓, as households
will borrow against their higher expected future income.

The takeaway from this hypothetical example is that what matters

for the determination of the current account is the expected path
of income, not just current income.

This point is important for analyzing actual historical episodes, as

the example on the next slide illustrates.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Imperfect Information, the Price of Copper and the Chilean

Current Account

We will look at the dynamics of the Chilean current account during

the copper price boom of the early 2000 and argue that the observed
dynamics are consistent with the predictions of the intertemporal
theory of the current account if one takes into account that Chile
underestimated how long the copper price boom would last and to
what heights the copper prices would rise.

Copper is the main export product of Chile (more than 50% of

exports). Thus, an increase in the world copper price represents a
positive terms-of-trade shock for Chile.

In the early 2000s, the price of copper began to rise vigorously

(it more than tripled) after it had been relatively stable during the
preceding two decades. (See the figure on the next slide.)
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 Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Forecast versus Actual Price of Copper, Chile, 2001–2013

400

350

300

250

200

150

100

Actual Copper Price

Forecast over next 10 years
50
2001 2003 2005 2007 2009 2011 2013

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Observations on the figure: (1) The crossed broken line shows the
actual real price of copper in U.S. dollar cents of 2015 per metric
pound from 2001 to 2013. (2) Between 2003 and 2007, the copper
price rose from 120 to over 350 cents and then stayed that high
until the end of the sample, 2013. [Yes, there was a dip during the
global financial crisis of 2008, but it was temporary.]

Mapping this episode into our model, we can think of the period
2003-2007 as period 1 and the years after 2007 at period 2, and
that T T1 increased and that T T2 also increased by as much as T T1
if not more.

The intertemporal theory of the current account, then predicts that

CA1 should not have improved, it should either have stayed the same
(under the interpretation that T T1 and T T2 both went up by about
the same) or it should have deteriorated (under the interpretation
of the data that T T1 went up and T T2 went up by even more).

Let’s take a look at the graph on the next slide to see if this is what
actually happened.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The Current Account, Chile, 2001-2013

2
percent of GDP

−1

−2

−3

−4
2001 2003 2005 2007 2009 2011 2013

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The figure on slide 12 shows the Chilean current account experienced

a significant improvement between 2003 and 2007 from deficits of
around one percent of GDP to surpluses of about three percent of
GDP.

This behavior of the CA contradicts, on the face of it, the predictions

of the intertemporal theory of the current account. However, this
prediction of the model hinges on the assumption that people had
perfect foresight about the copper price. But the assumption that
people could forsee that the rise of the price of copper would be
long lasting turns out to be wroing.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

How do we know? Take again a look at the figure on slide 10.

It also plots the forecast of the average real price of copper over the
next ten years produced by Chilean economic experts.

The plot reveals that until 2007 the experts expected the increase
in the copper price to be transitory. For example, in 2005 experts
predicted that the average copper price between 2005 and 2015
would be below 100. Only by 2013, did forecasters seem to believe
that high copper prices were there to stay.

In light of these expectations about the path of the price of copper,

the behavior of the current account is no longer in conflict with
the predictions of the intertemporal model. For it predicts that in
response to an improvement in the terms of trade that is expected
to be temporary, the current account should improve, which is what
indeed happened.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

World Interest Rate Shocks

Movements in world interest rates have been identified as impor-

tant factors driving business cycles and the external accounts in
economies that are open to trade in goods and financial assets.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

What happens when the interest rate changes? Two potentially

opposing effects:

Substitution Effect: A higher interest rate makes bonds more

attractive ⇒ consumption falls and saving increases.

Income Effect:
– If households are borrowing, the interest rate hike makes them
poorer (income effect is negative) ⇒ consumption falls and saving
increases. In this case, the income and substitution effects reinforce
each other.

– If households are lending, the interest rate hike makes them richer
(income effect is positive) ⇒ consumption increases and saving falls.
In this case, the income and substitution effects oppose each other.

[When the income and substitution effect oppose each other, we

assume that preferences are such that the substitution effect dom-
inates to ensure that saving is always an increasing function of the
interest rate.]
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Adjustment to an Increase in the World Interest Rate

The next figure displays the effect of an increase in the world interest
rate on consumption.

• Prior to the interest rate increase, the optimal consumption path

is point B.

• Then the world interest rate increases from r∗ to r∗ + ∆. This

causes the intertemporal budget constraint to rotate clockwise around
the endowment point A (we are assuming that B0 = 0).

• The new optimal consumption path is point B0.

• The increase in the interest rate causes period-1 consumption to

fall from C1 to C10 and period-2 consumption to increase from C2 to
C20 .

• Thus, the trade balance T B1 = Q1 − C1 and the current account

CA1 = T B1 + r0B0 both improve.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Adjustment to an Increase in the World Interest Rate

(B0 = 0)

C2
← slope = −(1 + r∗ + ∆)

slope = −(1 + r ∗ ) →
Q2 A

C20 B0

C2 B

Q1 C10 C1 C1

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Import Tariffs

Does an increase in import tariffs reduce imports and thereby im-

prove the trade balance?

It turns out that an increase in import tariffs can have either a

positive, a negative, or no effect on a country’s trade balance.

What matters is not the import tariff per se but how it compares to
expected future import tariffs.

Intuitively, if the current import tariff is higher than the future one,
then imports are relatively expensive in the current period and import
demand should fall. This would improve the trade balance in the
current period.

But if the imposition of import tariffs is permanent, then there is

no reason to shift consumption across time periods, and the import
tariff will have no effect on the trade balance.
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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

How to embed an import tariff in our model?

• Assume that there are two goods, an export good and an import
good as in the analysis of terms-of-trade shocks.

• Assume that the government rebates the revenues generated by

the import tariff to households in a lump sum fashion.

• Let τt denote the import tariff in period t = 1, 2.

• Let Lt denote the lump sum transfer in period t = 1, 2.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Household budget constraints in periods 1 and 2:

(1 + τ1)C1 + B1 = T T1 Q1 + L1 + (1 + r0)B0 (1)

(1 + τ2)C2 = T T2Q2 + L2 + (1 + r1)B1. (2)

The intertemporal budget constraint:
(1 + τ2)C2
(1 + τ1 )C1 + = Ỹ , (3)
1 + r1
where
T T2Q2 + L2
Ỹ = (1 + r0)B0 + T T1Q1 + L1 +
1 + r1
is lifetime wealth, which the household takes as given.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The Household’s Maximization Probem

max U (C1 ) + βU (C2 )

{C1 ,C2 }

subject to (3). Solve (3) for C2 and use resulting expression to

replace C2 from the household’s lifetime utility function. This yields
!
1 + r1
max U (C1) + βU (Ỹ − (1 + τ1)C1) .
{C1} 1 + τ2
The first-order condition associated with this problem is the Euler
equation
1 + τ1
U 0(C1) = β(1 + r1)U 0(C2). (4)
1 + τ2

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

The government rebates any revenue from the import tariff to

households in a lump sum fashion

The government budget constraint in period t = 1, 2:

Lt = τt Ct
Combining this expression with the households’ intertemporal budget
constraint (2) gives the economy-wide resource constraint
C2 T T2Q2
C1 + = (1 + r0)B0 + T T1Q1 + , (5)
1 + r∗ 1 + r∗
which is the same as in the economy without tariffs. This is intuitive
because the government returns the tariff revenue to its citizens
(who paid for the tariffs).

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

An equilibrium is a consumption path (C1, C2) and a domestic

interest rate r1 such that the Euler equation (4) holds, the economy
wide resource constraint (5) is satisfied and interest rate parity holds,
that is,
0 1 + τ1
U (C1) = β(1 + r1)U 0(C2) (4)
1 + τ2
C2 T T2 Q2
C1 + = T T1 Q1 + (1 + r0)B0 + (5)
1 + r∗ 1 + r∗
and
r1 = r ∗ , (6)
given τ1 , τ2, T T1Q1 , T T2Q2, (1 + r0)B0, and r∗.

We are now ready to analyze the adjustment to changes in import

tariffs.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

A Temporary Increase in Import Tariffs

Experiment: Initially τ1 = τ2 = 0.

Then a temporary tariff is imposed: ∆τ1 > 0 and ∆τ2 = 0.

The figure on the next slide shows the adjustment:

Prior to the imposition of import tariffs (τ1 = τ2 = 0) the optimal consumption

path is at point B.

Changes in import tariffs leave the intertemporal resource constraint (the down-
ward sloping solid line) unchanged.

A temporary increase in import tariffs (∆τ1 > 0 and ∆τ2 = 0) pushes the optimal
consumption path to point C, where the slope of the indifference curve (the
broken line) is steeper than at point B, (1 + τ1)(1 + r∗ ) > (1 + r∗). The increase
in import tariffs causes period-1 consumption to decline (C10 < C1), and the trade
balance in period 1 to improve (T T1Q1 − C10 > T T1Q1 − C1 ).

The indifference curve associated with point C lies southwest of that associated
with point B implying that the tariff is welfare reducing.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Adjustment to changes in import tariffs

C2

. slope = −(1 + τ1 )(1 + r∗ )

C20 C

C2 B

slope = − 1+r
∗
%
1+τ2 D
C200

← slope = −(1 + r∗ )

C10 C1 C100 C1

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

A Permanent Increase in Import Tariffs

Experiment: Initially τ1 = τ2 = 0.

Then a permanent tariff is imposed: ∆τ1 = ∆τ2 > 0.

The permanent increase in import tariffs has no effect on the equi-

librium consumption path because the import tax rates cancel out
of the Euler equation (4).

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

An Anticipated Future Increase in Import Tariffs

Experiment: Initially τ1 = τ2 = 0.

In period 1, agents learn that a tariff will be imposed in period 2: ∆τ1 = 0 and
∆τ2 > 0.

The figure on slide 26 shows the adjustment.

Prior to the imposition of import tariffs (τ1 = τ2 = 0) the optimal consumption

path is at point B. Changes in import tariffs leave the intertemporal resource
constraint (the downward sloping solid line) unchanged.

An anticipated future increase in import tariffs (∆τ2 > 0 and ∆τ1 = 0) pushes the
optimal consumption path to point D, where the slope of the indifference curve is
flatter, (1 + r∗)/(1 + τ2 ) < (1 + r∗ ). The expected future increase in import tariffs
causes period-1 consumption to increase from C1 to C100 and the trade balance to
deteriorate in period 1.

The indifference curve associated with point D lies southwest of that associated
with point B implying that the tariff is welfare reducing.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Summing Up (1/3)

This chapter analyzes the effects of terms-of-trade shocks and interest-

rate shocks in the context of the intertemporal model of the current
account developed in chapter 3.

• The terms of trade is the relative price of export goods in terms

of import goods.

• Terms-of-trade shocks have the same effects as endowment shocks:

the economy uses the current account to smooth consumption over
time in response to temporary terms of trade shocks, and adjusts
consumption with little movement in the current account in response
to permanent terms-of-trade shocks.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Summing Up (2/3)
• Interest rate shocks have a substitution and an income effect.

• By the substitution effect, an increase in the interest rate discourages current

consumption and incentivizes savings causing the current account and the trade
balance to improve.

• The income effect associated with an increase in the interest rate depends on
whether households are borrowing or lending.

• If households are borrowing, an increase in the interest rate has a negative

income effect, as it makes borrowers poorer. As a result, consumption falls and
the trade balance and the current account improve. In this case, the income and
substitution effect go in the same direction.

• If households are lending, the income effect associated with an increase in the
interest rate is positive and leads to higher consumption and a deterioration in the
trade balance and the current account. In this case, the income and substitution
effects go in the opposite direction, partially offsetting each other. Under log-
preferences the substitution effect dominates.

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Schmitt-Grohé, Uribe, Woodford, “International Macroeconomics: A Modern Approach” Chapter 4: Terms of Trade, the World Interest Rate, Tariffs, and the CA

Summing Up (3/3)

• An increase in import tariffs need not improve the trade balance

or the current account. Only if import tariffs are temporary, will
they lead to an improvement in the trade balance and the current
account. Future expected increases in import tariffs deteriorate the
trade balance. Permanent changes in tariffs leave the trade balance
unchanged.

• In the present framework, import tariffs are welfare decreasing.

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