RDP 2013-09: Terms of Trade Shocks and Incomplete Information 7. Conclusion

This paper has examined the extent to which agents are uncertain about the persistence of terms of trade shocks and described the effect of these shocks when agents have incomplete information. The results suggest that agents find it difficult to identify whether terms of trade disturbances are permanent or transitory in real time. In fact, the empirical results suggest that agent's expectations about the evolution of the terms of trade are largely invariant to the type of shock that hits the economy. A corollary of this result is that we should not expect households or firms to respond to terms of trade shocks in a first-best manner. Instead, at least in the model presented in this paper, in response to a temporary positive shock agents will consume more and produce less than in a full information environment. And, in response to a permanent shock, agents will consume less and produce more than they would if they had full information. But despite the fact that agents make mistakes in identifying the source of terms of trade shocks, incomplete information about these shocks does not increase macroeconomic volatility.

A number of extensions to this work deserve consideration. First, it may be worthwhile to replicate the estimation for other small open economies, including those featured in Figure 1. In particular, it would be interesting to learn whether the extent of incomplete information, and the effect of terms of trade noise shocks, differs between an advanced economy like Australia and a developing small open economy like Brazil or Chile. It may also be interesting to extend the model to include a non-traded sector and to incorporate nominal rigidities, including sticky wages and prices into the model. The former extension might reveal whether incomplete information about relative prices in the tradeable sector could have spillover effects to the rest of the economy. In particular, it may be interesting to see whether incomplete information about terms of trade movements could cause ‘Dutch disease’ type effects on the non-commodity sectors of the economy. Finally, the inclusion of nominal rigidities could allow one to examine how uncertainty about the persistence of terms of trade shocks affects monetary policy.