Preliminary

The paper studies the effect of terms of trade fluctuations on equilibrium debt position of a small open economy. I develop a simple model of a small open economy producing exportable and nontradable goods to investigate the effects of terms of trade shock assuming that terms of trade follow two state Markov switching process. Under this process, permanent terms of trade shock means change of regime. With switching probability, rational agent optimizes debt position according to the current state and the probability of transition. I define switching effect using transition probability and state dependent parameters. Unlike traditional argument, permanent terms of trade shock now has either positive or negative effect depending on the magnitude of state-contingent parameter. ∗This topic was motivated by my advisor prof.Eric Leeper. I would like thank prof.Eric Leeper, prof.Edward Buffie and prof.Brian Peterson for helpful comments. All errors are mine. 1