The Terms of Trade and Economic Fluctuations

IMF Working Papers, November 1, 1992

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A three-good, stochastic intertemporal equilibrium model of a small open economy is used to examine the link between terms of trade and business cycles.
Equilibrium co-movements of model economies representing industrial and developing countries are computed and compared with the stylized facts of 30 countries.
The results show that terms-of-trade shocks account for half of observed output variability and that the model mimics the Harberger-Laursen-Metzler effect and produces large deviations from purchasing power parity.
The elasticity of substitution between tradable and nontradable goods and the persistence of the shocks play a key role in producing these results.

Model type: three-good, stochastic intertemporal equilibrium model of a small open economy.
Comparative approach: model economies representing industrial and developing countries.
Empirical benchmark: stylized facts of 30 countries.

Terms-of-trade shocks account for half of observed output variability.
The model mimics the Harberger-Laursen-Metzler effect.
The model produces large deviations from purchasing power parity.
Key parameters influencing results:
- The elasticity of substitution between tradable and nontradable goods.
- The persistence of the shocks.

Subject: Business cycles, Consumption, Economic growth, Import prices, International trade, National accounts, Prices, Terms of trade, Trade balance
Keywords: Africa, Asia and Pacific, Business cycles, Consumption, form terms of trade, Import prices, Middle East, open economy, real GDP, standard deviation, Terms of trade, terms-of-trade disturbance, terms-of-trade effect, terms-of-trade shock, Trade balance, U.S. dollar, Western Hemisphere, WP