Summary of WP/92/98
“The Terms of Trade and Economic Fluctuations” by Enrique G. Mendoza
This paper examines the relationship between economic fluctuations and terms of trade disturbances in the context of a stochastic intertemporal equilibrium model of a small open economy. The analysis aims to establish whether terms of trade shocks can account for a significant part of observed output variability, and whether the intertemporal equilibrium approach can explain the positive response of the trade balance to an improvement in the terms of trade--the Harberger-Laursen-Metzler effect--and fluctuations in real exchange rates of the magnitude observed in the past two decades.
The model’s equilibrium co-movements, computed using recursive numerical simulation methods, reproduce many of the characteristics of recent economic fluctuations in the Group of Seven and 23 developing countries. In particular, a Harberger-Laursen-Metzler effect, which is stronger in industrial countries, and substantial deviations from purchasing power parity, which are larger in developing economies, are observed. The results also show that the model explains more than 50 percent of the observed variability of output in industrial countries. The intertemporal and intratemporal income and substitution effects that interact in the model to produce these results are examined by analyzing sensitivity to changes in the model’s parameters and by constructing impulse response functions for the alternative parameter specifications.
The results of this analysis suggest that, despite the unquestionable role of nominal disturbances in explaining some aspects of the business cycle, terms of trade and productivity shocks themselves play an important role. Even when no market failure, no imperfections of capital markets, and no barriers to capital mobility are evident, small open economies may experience significant fluctuations in economic activity, the external balance, and the real exchange rate simply as the optimal response of economic agents to disturbances affecting export and import prices.