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How Important Are Terms Of Trade Shocks?

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❶In the past few years, the world has witnessed large swings in world relative prices, from oil, to metals, to food prices.

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Similar results obtain for the other variables included in the SVAR model. These results suggest that there is a disconnect between theoretical and empirical models when it comes to gauging the importance of terms-of-trade disturbances in generating business cycles. Explaining this disconnect between empirical and theoretical models is an important item in the research agenda that lies ahead.

Its resolution is likely to involve a combination of better empirical and theoretical models as means to interpret the data. This is likely to be the case especially for countries whose exports or imports are concentrated in a small number of commodities. At the same time, the theoretical model could be amended by assuming that the government uses tax or commercial policy to isolate domestic markets from swings in world prices. In this case, movements in the terms of trade will elicit attenuated incentives to change the domestic allocation of output and absorption.

A related reason why fluctuations in the terms of trade may not have large domestic effects could be the presence of nominal rigidities that introduce a wedge between domestic and world prices. The jury is still out on whether future research will bring the empirical models closer to the predictions of the theoretical ones or vice versa, or whether the two will meet somewhere midway.

Progress on this research agenda will add much needed light on determining more accurately how important terms-of-trade movements are in generating business cycles in poor and emerging countries. NBER working paper , June. How important are terms-of-trade shocks? Share of variance of output explained by terms-of-trade shocks Explaining this disconnect between empirical and theoretical models is an important item in the research agenda that lies ahead.

Professor of Economics, Columbia University. De Gregorio, Eichengreen, Ito, Wyplosz. Income inequality in France. Trust and the lending activities of banks and fintech firms.

The Economic Consequences of Brexit. Homeownership of immigrants in France: Evidence from Real Estate. Giglio, Maggiori, Stroebel, Weber. The Permanent Effects of Fiscal Consolidations. Demographics and the Secular Stagnation Hypothesis in Europe. The difficulty of predicting the likely duration of commodity price shocks limits the ability of African policymakers to manage commodity booms and slumps.

Given the problems in reliably forecasting commodity prices, some analysts have recommended that countries adopt simple policy rules, such as making fundamental adjustments in response to all price shocks except those that can be unambiguously identified as temporary. The same difficulties are involved in assessing the duration of shocks to the terms of trade.

Is it possible to provide estimates of the typical duration and variability of terms of trade shocks that may allow for a deviation from this simple rule?

Using annual World Bank data for on the net barter terms of trade indices of 42 sub-Saharan countries, we calculate the length of time it typically takes for the effects of terms of trade shocks to dissipate, estimate the variability of the duration of terms of trade shocks, and measure the typical size of terms of trade shocks see box on page We also examine the implications of these results for African policymakers.

In forming projections of the likely duration of a particular terms of trade shock, policymakers can and should use episode-specific information—such as weather-related factors that are catalysts for large, short-lived movements in supply and, consequently, in world commodity prices.

In addition, the typical duration of past terms of trade shocks, as calculated here, contains valuable information that can augment this episode-specific information. However, it should be kept in mind that once policymakers have formed a view of the likely duration of terms of trade shocks, their desired policy response may be constrained by financial market imperfections. For example, while many African countries presently do not have access to international capital markets to facilitate the smoothing of national consumption in response to external shocks, there is important scope for domestic policy responses, particularly saving decisions, in dampening the effects of such shocks.

How long do shocks last? We find that, on average, the persistence of terms of trade shocks varies widely—for about half the sub-Saharan countries, such shocks are short lived that is, half of the effect of the initial shock typically dissipates in less than four years and for one-third of the countries such shocks are long lived that is, permanent. The average duration, in years, of terms of trade shocks for each country is displayed in descending order in Chart 1.

We find that the reversion of terms of trade to their mean as measured by the shock's half-life typically takes less than four years for 23 of the 42 countries. These countries have some scope to smooth national consumption by altering domestic savings in response to temporary terms of trade shocks.

The potential benefits of informed savings responses are greatest for countries with shocks lasting less than two years—that is, for 16 of the 42 countries. The range of the duration of terms of trade shocks is also shown in Chart 1. For example, terms of trade shocks in Mozambique last from 0. Five percent of the time, shocks in Mozambique will last longer than 3 years, while 5 percent or more of the shocks to Tanzania will be permanent.

This implies that, in the event of a terms of trade shock, it is likely to be much more important for Mozambique than for Tanzania to alter domestic saving to smooth national consumption, because the former has a much greater chance of experiencing short-lived shocks than the latter.

Also, because the range of the duration of terms of trade shocks experienced by Tanzania is much wider than the range experienced by Mozambique, the variability of shocks is likely to be greater for Tanzania.

In contrast, consider the 11 countries that typically experience very long-lived permanent terms of trade shocks. For these countries, half of the shocks will be finite and half will be permanent. Although these results do not rule out a change in domestic saving as a useful means of smoothing national consumption following terms of trade shocks, these countries are much likelier to experience long-lived shocks, which may make such switches between consumption and saving financially unsustainable.

How large are shocks? While it is particularly important to ascertain the duration of shocks to the terms of trade, knowledge of the typical size of terms of trade shocks is also of great interest. Shocks that are typically small but long lived will have different implications for the setting of macroeconomic policies than large, long-lived shocks. In this connection, we can measure the size of shocks to the terms of trade, using the standard error of the regression analysis that calculates the duration of terms of trade shocks.

As these errors are normally distributed, this implies that two-thirds of the time any change in the terms of trade is within one standard error of the initial level of the terms of trade, and one-third of the time any change is larger than one standard error.

The values for the standard error of the regression for each country are displayed in descending order in Chart 2.


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The terms of trade shock reduces the marginal product of factors in the exportable sector, and resources shift away from the tradable sector. Nontradable output, however, could either grow or shrink, depending on which dominates—.

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How important are terms-of-trade shocks? Stephanie Schmitt-Grohe, Martín Uribe 20 July This column examines how important these terms-of-trade shocks are in explaining GDP fluctuations.

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How Important Are Terms Of Trade Shocks? Stephanie Schmitt-Grohé, Martín Uribe. NBER Working Paper No. Issued in June , Revised in November NBER Program(s):International Finance and Macroeconomics According to conventional wisdom, terms of trade shocks represent a major source of business cycles in emerging and poor countries. We show that a shock to the terms of trade can affect the supply of productive factors like labor and that the effects of these shocks, as in the simple examples, also have an ambiguous impact on real GDP at base period prices.

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current terms of trade relative to the base period terms of trade. If the current import price is the same as the base period price, then the shock has no effect. Terms of Trade Shocks: What Are They and What Do They Do? are fairly standard. The third shock, a globalisation shock that may result, for instance, from the increasing importance of China, India and eastern Europe in the global economy, is more novel. Determining the underlying source of variation in the terms of trade is shown to be.