RDP 2015-11: Unprecedented Changes in the Terms of Trade 7. Conclusion

The development of Asia over the past decade or more led to unprecedented increases in global commodity prices and large increases in the terms of trade of economies that export substantial quantities of commodities. A recurrent question has been the degree to which these changes are permanent. Our objective has been to estimate the permanent change in the level and volatility of commodity export prices and to measure the consequences with the aid of a structural model.

A contribution of our paper is that we treat trends and cycles in a model-consistent way. Economic theory asserts that permanent changes in the terms of trade must influence other relative prices. In open economies, non-tradeable prices, consumer prices, investment prices, foreign output, foreign prices, real investment and real output all grow at different trend rates. Because our model's balanced growth path has these trends, we can identify the extent to which trends, cycles and breaks drive the fluctuations in the data.

We detect a change in the long-run level and volatility of Australia's terms of trade. We find that the long-run level of commodity export prices increased by around 40 per cent starting in 2003. This estimate is less than what casual observation might suggest and less than what single-equation structural break tests indicate. In forward-looking general equilibrium models a change in the long-run mean of the terms of trade manifests itself in the other observable series we use in estimation. Inferences from single-equation models that are not grounded in theory can yield implausible predictions. Using more observable variables in structural estimation helps us to identify the long-run level of commodity prices. Although general equilibrium estimates are less than what may be inferred otherwise, the estimated change in the long-run level of commodity prices has a significant impact on the economy.