The Institute for Economic Development at Boston University -------- ------------------------Research Review Spring 2001

“What Can Account for Fluctuations in the Terms of Trade?”
Marianne Baxter and Michael Kouparitsas
IED Discussion Paper 112, December 2000

Extreme volatility in terms of trade is a well documented empirical phenomenon world-wide. Sharp movements in terms of trade can potentially lead to sudden changes in a country’s trade balance and current account and, in several cases, a possible difficulty in financing the national debt burden. Within a country sharp movements in terms of trade can cause severe sectoral imbalances with respect to output and wages. These fluctuations have therefore been a perennial source of concern to policymakers in developing countries and industrialized nations alike who wish to avoid both the difficulties with financing current account imbalances as well as the internal imbalances. Pinning down the source of these shocks can help in devising policies that can mitigate the ensuing economic disruption. This paper by Baxter and Kouparitsas is a contribution toward the search for the source of terms of trade shocks.

Relative price volatility of different bundles of goods (for example, manufactures and fuels) has long been recognized as an important source of terms of trade shocks owing to countries often having very different export and import goods baskets. In addition, Baxter and Kouparitsas point out that in spite of their diversified export baskets industrialized nations also suffer from large terms of trade fluctuations. This seems to be indicative of market imperfections that preclude the law of one price to operate in world markets. This may 		then turn out to be a major explanation for terms of trade fluctuations. Baxter and Kouparitsas use World Bank data on exports and imports for 100 countries and three major categories of goods to decompose a country’s terms of trade volatility into two components: one stemming from differences in the composition of import and export baskets which represents the (relative) goods price effect, and the second component owing to cross-country differences in the price of a particular class of goods. They consider two alternate decompositions both consistent with this methodology.

A number of insights are generated through such a decomposition procedure. Baxter and Kouparitsas find that, while for fuel exporting countries most of the terms of trade variations do indeed stem from goods price effects, for countries that export non-fuel commodities no such generalization is possible since there is great dispersion in the importance of either effect. The paper also exposes some inherent weaknesses in the early open economy business cycle macro models. For example, both decompositions unearth a significant impact of country price effects indicating that international business cycle models should explicitly account for market imperfections such as trade barriers if they are to track terms of trade volatility accurately. In a similar vein, most early models that focused on a small number of production sectors and production of durable goods produce very little terms of trade volatility. The results of this paper suggest the need to incorporate production and trade of non-manufactured goods (fuel and commodities) into these models.

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