RDP 2009-05: Macroeconomic Volatility and Terms of Trade Shocks 2. Literature

Terms of trade shocks have been found to be an important source of macroeconomic volatility. Using a small open economy real business cycle model, Mendoza (1995) estimates that roughly one-half of the variation in aggregate output in a sample of the G7 and 23 developing economies can be attributed to terms of trade shocks. Kose (2002) applies a similar framework and finds that terms of trade shocks can explain almost all of the variance in output in small open developing economies. Changes in the terms of trade affect output to the extent that they alter the volume of imports that can be purchased for a given volume of exports and hence the economy's real domestic income.[3] The resulting fluctuations in domestic spending may well be reflected in inflation, both directly through the shock's impact on domestic prices and wages, and indirectly through its effect on output.

While terms of trade shocks have the potential to affect macroeconomic stability, the transmission of such shocks to the broader economy varies across countries. For instance, terms of trade shocks are likely to have a greater effect on macroeconomic volatility in countries more open to international trade, as terms of trade shocks will have their most direct effects on the tradable sector of an economy (Beck, Lundberg and Majnoni 2006). The effect of shocks can also vary across countries due to differences in national economic institutions (Blanchard and Wolfers 2000), including the nature of an economy's exchange rate and monetary policy regime, the level of financial sector development and labour market flexibility.

Economies with more flexible exchange rates are likely to be better able to accommodate terms of trade shocks than those with fixed exchange rates. Broda (2004) and Edwards and Levy Yeyati (2005), for example, using cross-country panel data find that the cumulative reduction in real GDP following a decline in the terms of trade is much larger in economies with fixed exchange rates than economies with floating exchange rates. This is consistent with the idea that, given an adverse terms of trade shock, a country with a flexible exchange rate will adjust through a currency depreciation, which tends to offset the shock's negative effects on output via a boost in external competitiveness. Moreover, if nominal wages are sticky, the depreciation of the exchange rate can reduce real wages at a time when labour demand is likely to be weak (Meade 1951). By contrast, the equilibrium real exchange rate under a fixed exchange rate regime has to adjust through changes in domestic nominal prices and wages. In the presence of nominal rigidities, this process can imply particularly large output costs. Flexible exchange rates also have the potential to ameliorate the impact of terms of trade shocks on inflation. For the case of Australia, Gruen and Dwyer (1995) concluded that a sufficiently large appreciation of the real exchange rate can offset the inflationary impact of a positive terms of trade shock.

Our paper builds on the existing literature in a number of ways. Specifically, we focus on the impact of unanticipated volatility in the terms of trade – that is, terms of trade shocks – on macroeconomic volatility (see Section 3). In contrast, Edwards and Levy Yeyati (2005) focus on the rate of change in the terms of trade which does not allow for the potentially different macroeconomic effects of anticipated and unanticipated movements. While Broda (2004) also identifies unanticipated changes in the terms of trade by employing a VAR framework, our paper also controls for other institutional characteristics that are likely to affect the propagation of terms of trade shocks, including the nature of a country's monetary policy regime. The latter is potentially important to the extent that while flexible exchange rate regimes enable countries to pursue an independent monetary policy, discretionary monetary policy can also serve as a source of shocks, as well as a stabilising tool (Clark and van Wincoop 2001).

While Kent, Smith and Holloway (2005) also find a role for the conduct of monetary policy in explaining the trend decline in OECD output volatility, their analysis does not distinguish between the role of the monetary policy framework in the propagation of shocks and the size of these shocks. In this paper, we allow for the possibility that the monetary policy framework affects the propagation of terms of trade shocks. For example, if a rising terms of trade warrants tighter monetary policy in order to stabilise inflation, countries with a monetary policy regime that focuses on low inflation are more likely to deliver this policy adjustment. Alternatively, if the shock is perceived to be short-lived, there is some scope for monetary policy to look through the stimulus if inflation expectations are well-anchored (Stevens 2008),[4] otherwise the shock has the potential to fuel wage and price inflation.

The nature of the financial system will also matter if more developed financial markets allow agents to better smooth their expenditure decisions and deal with fluctuations in the exchange rate and other prices in the face of terms of trade shocks. However, the overall effect of financial market development on macroeconomic volatility is ambiguous to the extent that more developed financial markets can amplify shocks, such as to banks' balance sheets, implying greater output volatility (Beck et al 2006). While Beck et al find only weak evidence that financial development dampens the effects of terms of trade volatility on output volatility, we test this hypothesis more directly by investigating the impact of terms of trade shocks on the volatility of expenditure components of GDP, including consumption and investment. To the best of our knowledge, this disaggregated approach to analyse how economic institutions affect the propagation of terms of trade shocks distinguishes our paper from most others in the literature.

Kent et al (2005) also find a role for labour and product market reform in explaining the decline in OECD output volatility over recent decades (at least up until 2003). Reforms to factor markets can reduce output volatility by encouraging productive resources to shift more readily in response to differential shocks across firms and sectors. Accordingly, an economy's adjustment to terms of trade shocks might also depend on the relative flexibility of its labour market. If real wages are inflexible, the ability of floating exchange rates to temper the effect of terms of trade shocks on macroeconomic volatility becomes limited (Meade 1951; Edwards and Levy Yeyati 2005). Real wage inflexibility can arise directly from wage indexation, or be a product of high levels of unionisation and strict employment protection legislation (Clar, Dreger and Ramos 2007).

In a paper drafted contemporaneously with this one, Rumler and Scharler (2009) find that in a panel of 20 OECD countries, the effect of fluctuations in the terms of trade on output volatility is amplified in economies where trade union density is high. However, they also find that more co-ordinated labour markets (that is, where the level of communication between labour unions representing different groups is high) can have a stabilising effect.[5] Given that the volatility in Australia's terms of trade often lies between that of a typical industrialised and typical developing economy (Table 1), it makes sense for us to extend this analysis to also include non-OECD economies.


From the perspective of a firm in the export sector, a rise in export prices relative to import prices raises real producer returns (relative to consumer prices) for a given level of inputs, which could stimulate business investment and output (Grimes 2006). [3]

The anchoring of inflation expectations might occur through a well-understood inflation target. [4]

It is possible that unions internalise the macroeconomic consequences of their actions in economies with a high degree of labour market co-ordination (Calmfors and Driffill 1988). If unions care about the employment of existing members as well as the real wage, they will have an incentive to moderate wage demands in response to adverse macroeconomic shocks (Cukierman and Lippi 1999). [5]