Intermediate imports, the terms of trade, and the dynamics of the exchange rate and current account

This paper studies the macroeconomic effects of an increase in the price of an imported intermediate production input. The framework of the analysis is a small open economy with a floating exchange rate and endogenous terms of trade, in which saving depends on residents' (variable) rate of time preference. Contrary to popular conceptions, an intermediate price shock may lead to an appreciation of the exchange rate in both the short run and the long run, and is likely to occasion a current-account surplus. The terms of trade between foreign and domestic finished goods always improve in the long run.