Can exchange rate variations or trade policy alter the equilibrium current account?

Paul Krugman has pointed out that much work needs to be done before the intertemporal open economy model can replace the open economy IS/LM model as a guide to policy making. The objective here is to take a step in this direction by examining if an exogenous increase in world demand for home goods (as via trade policy) can improve the equilibrium current account within an open economy intertemporal model. In the process, the paper explores the theoretical issue as to whether a variation in the real exchange rate can alter the difference between saving and investment. The key idea is that uncovered interest parity plus some degree of mean-reversion in the real exchange rate imply that a modern version of the Laursen-Metzler-Harberger effect is operative. The result is that a policy induced increase in the trade balance will alter the real exchange rate, which, in turn, increases the difference between home saving and investment, and, thereby, improves the equilibrium current account. (c) 2005 Elsevier Ltd. All rights reserved.