This is a study of the current account dynamics resulting from the savings and investment dynamics in a small open economy which is subject to exogenous changes in its terms of trade and in world interest rates. Anticipated and unanticipated, as well as temporary and permanent, terms of trade changes have very different effects. There is, however, a general tendency towards cycles in both savings and investment, which gives rise to cycles in the current account. It is shown that the classic Harberger-Laursen-Metzler effect on saving of a terms of trade deterioration can have any sign for plausible parameter values, both for temporary and permanent disturbances.

This paper develops a simple general equilibrium model of a monetary economy with a capital market. Money demand arises from a “cash-in-advance” constraint rather than from any direct role in the utility function, and uncertainty gives rise to a meaningful portfolio choice between money and bonds. We show that velocity is increasing in the rate of inflation, and that the optimal monetary policy is that which maximizes real balances. We also show that the real rate of interest is not invariant to monetary, policy: inflation lowers the real rate.