The relationship between temporary terms of trade shocks and household saving in developing countries is examined. It is first shown that, from a theoretical standpoint, this relationship is ambiguous: private saving may rise or fall in response to a transitory terms of trade shock, depending on the values of the intertemporal elasticity of substitution and the intra-temporal elasticity of substitution between traded and nontraded goods. Empirical estimates of these two parameters are obtained using data from a sample of 13 developing countries, and then used to draw implications for the response of private saving to transitory terms of trade shocks. [JEL E21, F32, F41, 010, 053, 054, 055]
The terms of trade have historically been one of the most important exogenous determinants of the external positions of developing countries. Over the past two decades, sharp fluctuations in world market prices for primary commodities and two oil shocks, which substantially increased the price of imported energy products for non-oil developing countries, were associated with increased variability in the saving, investment, and current account behavior of these countries.
The theoretical literature on the relationship between the terms of trade and the current account has focused almost exclusively on how terms of trade changes affect private saving, ignoring any additional effects on investment and public saving.1 The traditional explanation—associated with the names of Harberger (1950) and Laursen and Metzler (1950)—suggests that an improvement in the terms of trade raises a country’s real income level, measured as the purchasing power of its exports in world markets, and hence, on the assumption that the marginal propensity to consume is less than unity, raises private saving. Thus, the Harberger-Laursen-Metzler (HLM) effect, as it has become known, hypothesized that improvements in a country’s terms of trade would be associated with increases in private saving, and conversely, adverse terms of trade shocks would reduce saving.
This view went largely unchallenged for nearly three decades, and was generally supported by the available empirical evidence. (See, for example, Khan and Knight (1983).) In the early 1980s, however, several studies re-examined the theoretical underpinnings of the HLM effect, a crucial building block of which was the Kcyncsian (static) relationship between consumption (or saving) and income. These studies, including, for example, those by Sachs (1981, 1982) and Svensson and Razin (1983), argued that household saving decisions should be derived from solutions to a dynamic optimization problem of choosing consumption levels at different points in time. As faras the HLM effect was concerned, the key insight provided by these models was that the relationship between the terms of trade and saving depended crucially on the expected duration of the terms of trade shock. For example, if households expected an improvement in the terms of trade to be permanent, then they would revise upward their estimate of permanent income in proportion to the increased purchasing power of their income today. Under the hypothesis that the marginal propensity to consume (save) out of permanent income is unity (zero), a permanent change in the terms of trade would therefore have no effect on saving, contrary to the HLM view.2 By contrast, in a situation in which the improvement in the terms of trade was expected to be only temporary, the increase in permanent income would be smaller than the increase in current income, and saving would accordingly rise.
Therefore, the HLM hypothesis was satisfied for transitory terms of trade disturbances, but apparently not for permanent ones.
At the same time, the view that transitory changes in the terms of trade have unambiguous effects on private saving is misleading for two reasons. When a country experiences a temporary adverse terms of trade shock that raises the price of current imports relative to future imports, consumers have an incentive to postpone their purchases—that is, to save more. So, while consumption-smoothing considerations—the basis for the HLM effect—imply that private saving should decline in response to the temporary real income decline, the so-called consumption-tilting motives imply that private saving Should increase as agents reduce current consumption in line with the increase in its relative price.3 On these grounds alone, therefore, what happens to saving is theoretically ambiguous and depends on the relative magnitudes of the consumption-smoothing and tilting motives. The parameter governing this latter motive is the intertemporal elasticity of substitution. Relatively large values of this parameter imply that, in response to a given (transitory) movement in the terms of trade and, hence, in the intertemporal relative price (consumption rate of interest), consumers increase their saving by a relatively large amount; it follows that the larger is this elasticity, the greater is the increase (the smaller the fall) in private saving in response to a transitory adverse shock to the terms of trade.
In addition, however, when there are nontraded goods, an adverse terms of trade shock will lead consumers to substitute away from relatively expensive imports in favor of home goods, thereby bidding up their relative price. If the terms of trade shock is temporary, the resulting temporary real appreciation will contribute to a further increase in the consumption interest rate and, hence, a further increase in saving.4 The parameter governing the switch from imports to home goods and, hence, the magnitude of the temporary real appreciation and increase in the consumption rate of interest is the infratemporal elasticity of substitution between tradables and nontradables. A relatively large value of this parameter implies a large increase in the consumption rate of interest and a commensurately large rise in saving. It may be concluded, therefore, that the larger are either the intertemporal or intratemporal elasticities of substitution, the greater will be the increase (the smaller the decrease) in private saving in response to a temporary adverse movement in the terms of trade. The outcome in any case is an empirical matter that can only be addressed through estimation of these two critical parameters.
The approach taken in this paper involves estimating the “structural” parameters of a representative household’s utility function. The basis for such an approach, in preference to the alternative of estimating reduced-form consumption or saving functions, is related to the Lucas critique. As is well recognized, the Lucas critique implies that there may not be anything that could properly be called a consumption or saving function, in the sense of a stable functional relationship that is independent of the wider macroeconomic context.5 In contrast to previous studies, we employ a disaggregated commodity structure according to which agents consume both traded and non traded goods. Disaggregation permits estimation of the two parameters of interest: the intertemporal elasticity of substitution and the infratemporal elasticity of substitution between tradables and nontradables. The data set employed is also suitable for comparing our findings to those of previous studies that employed a one-good structure. In contrast to many such studies, we find evidence that the intertemporal elasticity of substitution is significantly different from zero and lies in the 0.3 to 0.8 range, depending on the region considered. Intratemporal substitution elasticities are estimated to be significantly higher, and indicate that this parameter—which to our knowledge has been entirely ignored in previous Euler equation estimations for developing countries—plays a critical role in determining the sign and magnitude of the HLM effect in these countries.
Finally, although the empirical results of this paper can be used to analyze a variety of other issues—including the effects of permanent terms of trade shocks and the impact of trade reforms (which alter the internal terms of trade of the country that undertakes them)—we focus in what follows on temporary terms of trade shocks, mainly because recent empirical evidence relating to the developing countries suggests that the transitory component of such shocks is quantitatively important. 6 For instance, Cuddington and Urzua (1989) found that fully 60 percent of all shocks to commodity prices were of a temporary nature, and Mendoza (1992) reported a similar result relating to the terms of trade of developing countries.
The remainder of this paper is organized as follows. Section I illustrates the role of preference parameters in the HLM effect in the context of a simple two-period model that admits closed-form solutions. For the purposes of empirical implementation, however, Section II considers the stochastic, infinite-horizon version of this model and presents the optimality conditions for an intertemporal equilibrium model in which households consume both traded and nontraded goods. Section III describes the approach to estimation and presents the empirical results. The main conclusions are contained in Section IV.
APPENDIX Description and Sources of Data
This Appendix provides a description of the data analyzed in Section III and lists the sources used.
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Jonathan D. Ostry, an Economist in the Research Department, holds a doctorate from the University of Chicago, as well as degrees from the London School of Economics and Political Science, Oxford University, and Queen’s University.
Carmen M. Reinhart is an Economist in the Research Department. She holds a Ph.D. from Columbia University.
The authors wish to thank Mike Gavin, Mohsin S. Khan, Leo Leiderman, Enrique Mendoza, Peter Montiel, Assaf Razin, and Peter Wickham for useful comments.
For a discussion of investment effects of terms of trade changes in a somewhat different context, see Corden (1988).
A transitory adverse shock to the terms of trade raises the cost of current consumption relative to future consumption (the consumption rate of interest) because it temporarily raises the relative price of imports, which enters into the consumer price index. The latter, however, returns to its trend level once the terms of trade return to their trend level. For further details on the consumption rate of interest, see Dornbusch (1983).
See Ostry (1988). The reason is the same as given in the previous footnote. The transitory rise in the relative price of nontradables raises the consumer price index temporarily, making current goods more expensive relative to future goods.
On the usefulness of our estimates to the issue of permanent terms of trade shocks, see, for example, Ostry (1988), Gavin (1990), and Edwards and Ostry (1992); on their applicability to trade reform issues, see Calvo (1987), Ostry (1990, 1991,1992), Edwards and Ostry (1990), and Ostry and Rose (1992).
The model of this section is a simplified version of the one developed in Ostry (1988). A stripped-down version is presented here only for the purposes of illustrating the role of preference parameters in the HLM effect. The model to be estimated empirically is presented in Section II.
As is well known, the two-period assumption is not restrictive here, since the second period may represent the aggregation of a large (possibly infinite) number of future periods. The motivation for the two-period structure is that it allows us to obtain closed-form solutions for the response of private saving to terms of trade shocks, something that is precluded in the infinite-horizon version of the model developed later.
Without loss of generality, the numeraire is taken to be the exportable good. For recent evidence supporting the view that developing countries, in general, can be characterized as financially open economies, see Haque and Montiel (1991).
Although it is straightforward to obtain explicit solutions for the demand functions in this case, there is no particular interest in doing so. In equations (3a)–(3d), we have made use of the fact that the optimization problem as specified satisfies the assumptions necessary for two-stage budgeting (Goldman and Uzawa (1964)). Accordingly, demands in a given period depend only on relative prices in that period and aggregate spending in that period. The real value of aggregate spending, in turn, depends only on lifetime wealth and on the intertemporal relative price, R (the consumption discount factor, which is equal to 1 over 1 plus the consumption rate of interest).
Under the assumption of no historical debt commitments, this ratio is also equal to the ratio of the current account balance to GDP, since there is no investment or government saving in the model.
Clearly, both k and χ are positive fractions. If the horizon of households were infinite, a good proxy for k would be the real interest rate. It should also be noted that if there is no domestic production (or endowment) of import substitutes, χ is equal to unity.
See Chamberlain and Wilson (1984) for a fuller discussion of the appropriate no ponzi-game constraint in an infinite-horizon consumption model under uncertainty.
We assume that the inherited level of debt, A-1 is given and, for convenience, set equal to zero.
This is particularly relevant, since estimation of consumption Euler equations for developing countries has been confined to environments in which there is a single consumption good; see, for example, Giovannini (1985) and Rossi (1988).
All series are available upon request.
This may admittedly be a restrictive assumption in the case of some countries, but unfortunately, the data do not permit us to disaggregate consumption further.
To ensure consistency, all the series used to disaggregate consumption into its traded and nontraded components (GDP by sector, private consumption, exports, and imports) are on a national income accounts (NIA) basis.
The parameter a is some positive number that denotes the weight attached to the imported good in the period utility function. In the analysis that follows, a (which is not of immediate interest), is not jointly estimated with the remaining parameters. Instead, the following values were used: 0.85 for Africa, 1.14 for Asia, and 0.58 for Latin America. These values were obtained by estimating the nonstochastic first-order condition (equation (13)) using ordinary least squares (OLS). Since we tested for and found cointegration among relative prices and consumption of importables and nontraded goods, we know that OLS provides consistent parameter estimates for a. By imposing in the subsequent estimation the values of a, we increase the efficiency of the estimates of the remaining parameters. The estimates of є obtained by applying OLS to (13) were also used as the starting values in the subsequent GMM estimation.
This problem is not likely to arise with prices and interest rates, which are generally available monthly with little or no lag. However, for the consumer making two-period forecasts of consumption, it is not unlikely that overestimating (underestimating) today’s consumption level leads to a similar error in the subsequent period, making the two correlated.
This assumption will be relaxed later when regional estimates of the preference parameters are estimated.
A common procedure in the existing literature on estimation of Euler equations is to allow the instrument set to vary by introducing more lags, considering instrument sets such as
The J-statistic is distributed as χ2(n) under the null hypothesis. The degrees of freedom, n, are equal to the number of overidentifying restrictions.
Interestingly, these estimates are consistent with values in the 2.5-3.0 range for the coefficient of relative risk aversion (the reciprocal of the intertemporal elasticity of substitution) used in calibrating real business cycle models: see, for example, Stockman and Tesar (1990).
This is slightly higher than the estimates obtained by Backus, Kehoe, and Kydland (1991) for the United States.
Correct aggregation would apply utility-based weights to the various types of goods consumed. However, available aggregate price indices do not employ such a methodology.
Notice that the assumption of linearity itself involves a number of additional restrictions (particularly on the joint distribution of consumption and rates of return), relative to the model estimated in this paper.
Rossi (1988) argued that estimates of the intertemporal elasticity of substitution are biased downward if liquidity constraints are nottaken into account. The regional differences in estimates of σ may reflect this omission, since empirical evidence (see Haque and Montiel (1989)) indicates that the Asian countries in our sample are less liquidity constrained than their African counterparts. Unfortunately, the Haque-Montiel sample does not include any of the Latin American countries covered by this study.