RDP 2009-05: Macroeconomic Volatility and Terms of Trade Shocks 7. Conclusion

This paper explores the effect of terms of trade shocks on macroeconomic volatility using a panel of 71 countries from 1971–2005. We find that the volatility of terms of trade shocks has a statistically significant and positive impact on the volatility of output growth and inflation. We also explore how different policy frameworks and the structure of markets influence the transmission of terms of trade shocks. While there is evidence that monetary policy frameworks that focus on low inflation tend to reduce macroeconomic volatility in general, floating exchange rates seem to be the key to lower macroeconomic volatility for economies that are subject to sizeable terms of trade shocks.

We also examined how the volatility of terms of trade shocks affects the volatility of the main expenditure components of GDP. Our results suggest that terms of trade volatility primarily affects the volatility of the growth of household consumption, exports and imports. Perhaps surprisingly, investment volatility appears less affected by terms of trade shocks, although this could reflect the influence of the persistence of terms of trade shocks, or the inclusion of government and dwelling investment – dealing with these would be an interesting avenue for further research. Financial market development appears to dampen the effect of terms of trade shocks on the volatility of consumption growth. Monetary policy that focuses on low inflation and a flexible exchange rate regime help to stabilise imports in response to terms of trade volatility.

These results are broadly robust to alternative specifications, including the omission of large economies and non-commodity producers. When we re-estimated our models over a shorter sample from 1980 – a period of relative macroeconomic stability – we find a role for monetary policy, as well as flexible exchange rates, in reducing the volatility of output in the presence of large terms of trade shocks.

Overall, our results suggest that even though global movements in relative prices are beyond the control of policy-makers in small economies, policy-makers can still influence how those movements affect the economy.