RDP 2009-05: Macroeconomic Volatility and Terms of Trade Shocks 1. Introduction

The Australian economy has historically been subject to large swings in its terms of trade (Table 1), with these swings having a significant effect on both output and inflation. Over time, however, the impact of these swings on the economy appears to have lessened somewhat (see Figure 1 and the discussion in Gruen 2006), apparently reflecting changes to the overall policy framework and the structure of markets. By drawing on cross-country data, this paper formally examines the idea that the nature of the policy framework and the flexibility of markets have a significant effect on how economies respond to changes in their terms of trade.

Table 1: Terms of Trade Volatility
Standard deviation of terms of trade growth
Australia Industrialised economies Developing economies
1971–1980 8.5 5.6 16.2
1981–1990 6.3 5.0 13.6
1991–2000 4.8 3.5 9.9
2001–2009 7.9 3.1 6.7(a)

Note: (a) Data for developing economies only for period 2001–2005

Sources: see Appendix A. Data for 2009 are forecasts, sourced from the OECD Economic Outlook No 85.

Figure 1: Australia – Terms of Trade Booms and 
the Macroeconomy

We adopt an atheoretic approach based on cross-country panel data models, where the volatility of output and inflation (the dependent variables) are initially regressed on the volatility of terms of trade shocks – to account for the size of the shock – and a host of control variables. We then interact the terms of trade with a number of the control variables intended to represent the policy frameworks and the structure of financial and labour markets that are likely to be relevant for the propagation of terms of trade shocks.

In our sample of 71 countries for the period 1971 to 2005, we find that shocks to the terms of trade are an important source of output and inflation volatility.[1] While monetary policy regimes that focus on low inflation reduce macroeconomic volatility in general (particularly with respect to output),[2] floating exchange rates appear to provide the key macroeconomic stabilisation tool for economies that are subject to sizeable terms of trade shocks. Our results provide some evidence to suggest that in the presence of terms of trade volatility other structural features of an economy affect output volatility; there is weaker evidence for an effect of these structural features on inflation volatility. To obtain a better understanding of the effect on output, we adopt a disaggregated approach, estimating how terms of trade shocks and structural features affect the volatility of the various expenditure components of GDP. These results suggest that terms of trade volatility has its largest effect on the volatility of consumption, exports and imports. We also find that greater financial market development reduces the impact of terms of trade shocks on macroeconomic volatility, but that this effect occurs primarily through household consumption.

The rest of the paper is structured as follows. A brief review of the literature, and a discussion of how this paper extends existing research, is provided in Section 2. The data and methodological issues are discussed in Section 3. Estimates of the effect of the volatility of terms of trade shocks on output and inflation volatility, and the extent to which institutional arrangements condition these relationships are presented in Section 4. The analysis is extended in Section 5 to consider the effect of terms of trade volatility on the expenditure components of output growth. The sensitivity of the results to alternative econometric specifications is considered in Section 6, while conclusions are drawn in Section 7.


Our sample concludes in 2005 due to data constraints. Accordingly, our analysis does not cover the most recent period of heightened volatility associated with the sharp rise in commodity prices up to 2008 and the Global Financial Crisis. [1]

See Section 3 for a detailed discussion on how monetary policy is measured. While we find that monetary policy frameworks that focus on low inflation reduce output volatility in general, the effect on inflation volatility is more sensitive to the econometric specification chosen. However, the role that monetary policy plays in reducing inflation volatility could occur through other channels – for example, by keeping the average rate of inflation low and thereby providing an anchor for inflation expectations (see Section 4). [2]