RDP 2013-10: Stochastic Terms of Trade Volatility in Small Open Economies 8. Conclusion

This paper has contributed to the literature examining time-varying volatility in macroeconomics by studying the effects of changes in the volatility of the terms of trade, a plausibly exogenous relative price for small open commodity-exporting economies.

Our empirical estimates for six of these economies demonstrate that the magnitude of terms of trade shocks varies considerably over time. Using a panel VAR we demonstrate that a volatility shock reduces both consumption and investment. Aggregate output also decreases following the shock and the current account balance increases when the shock hits, and remains above trend before decreasing as domestic demand recovers. There is also a persistent decrease in the price level.

Our small open economy real business cycle model can replicate the responses to the volatility shock generated by the VAR. We use the model to explore the mechanisms behind these responses and to examine their sectoral impacts. In the model, a shock to terms of trade volatility reduces consumption, causes a boom in the tradeable sector at the expense of the non-tradeable sector and triggers a shift in the factor intensity of production away from capital towards labour. The decrease in domestic absorption and the increase in tradeables production leads to an increase in the trade balance that allows the economy to reduce its foreign borrowing.

The model allows us to quantify the contribution of terms of trade volatility shocks to the fluctuations of macro-aggregates. Although the direct contribution of terms of trade volatility shocks to the variance of key variables is rather small, we find that these shocks have a meaningful economic effect in interaction with shocks to the level of the terms of trade. Our estimates suggest that terms of trade volatility shocks account for between one-fifth and one-third of the total effect of the terms of trade on the volatility of output, consumption, investment and net exports in the countries in our sample.

Our results point to a number of promising avenues for further research. The disaggregated VAR results hint that, for emerging economies, the response to volatility shocks occur mainly through quantities while, for advanced economies, the response occurs mainly through prices. More detailed empirical work using a larger sample of economies could shed light on the robustness of this result. And, if it does turn out to be robust, further work would be needed to understand why this occurs.