INCOME EFFECTS OF ADJUSTMENT TO A TERMS OF TRADE DISTURBANCE AND THE DEMAND FOR ADJUSTMENT FINANCE

This paper shows that when economic adjustment is costly, and therefore takes place gradually, it is optimal to seek external finance in response to permanent as well as transitory shocks, while at the same time adjusting to the disturbance. Sluggish adjustment also creates an asymmetric relationship between (permanent) changes in the terms of trade and optimal foreign borrowing. That is, while a permanent deterioration in the terms of trade generates a demand for foreign loans, so would an improvement. The paper presents suggestive evidence that the effects may be empirically significant, though they arise from effects that are technically second-order of magnitude. © 1991.