Research Discussion Paper – RDP 2009-05 Macroeconomic Volatility and Terms of Trade Shocks Abstract

This paper explores the effect of terms of trade volatility on macroeconomic volatility using a panel of 71 countries from 1971–2005. It finds that terms of trade volatility has a statistically significant and positive impact on the volatility of output growth and inflation, although the magnitudes of these effects depend on the policy framework and the structure of markets. Specifically, adopting a more flexible exchange rate tends to ameliorate the effect of terms of trade shocks on macroeconomic volatility. The paper also finds some evidence that a monetary policy regime that focuses on low inflation helps to moderate the volatility of output and inflation in the face of a volatile terms of trade. The same is true of financial market development in the case of output volatility. Using data on the expenditure components of GDP, the channels through which terms of trade shocks affect output are examined. The results suggest that terms of trade volatility has its largest effect on the volatility of consumption, exports and imports. There is evidence to suggest that greater financial market development helps to mitigate the effect of terms of trade volatility on consumption volatility, while monetary policy that focuses on low inflation is associated with lower volatility of imports.

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