Primary Producers
Dollar up, terms of trade down

The experience of floating exchange rates in the 1970s and 1980s suggests that for exporters of primary products, the terms of trade appear to worsen when the dollar appreciates and to improve when it depreciates. This 'stylized fact' assumes even greater importance with the growing integration of world capital markets. International lending often takes the form of dollar-denominated debt, and changes in the dollar exchange rate affect not only terms of trade but also the burden of debt repayment and the size of serviceable debt. The prospects for growth in developing countries are therefore doubly dependent on the value of the dollar.

In Discussion Paper No. 90, Heywood Fleisig and Research Fellow Sweder van Wijnbergen argue that the conventional theory of price adjustment in competitive markets can be used to explain the relationship between primary commodity prices and the value of the dollar. Their approach is a partial equilibrium one, in which they investigate the effect on primary commodity prices of a change in the real exchange rate between the US dollar and the currencies of other industrialized countries.

The authors' analysis is straightforward. Suppose the dollar appreciates in real terms against the currencies of other industrial countries. Real commodity prices will therefore fall in terms of US goods and rise in terms of other industrial countries' goods. The fall in dollar terms and the decline in the terms of trade will be the larger, the smaller is the US share in the world market for that primary commodity and the lower the US elasticity of demand for the good relative to elasticities in other industrial countries. This accords with intuition, the authors argue. If the US market share is large or US demand elasticity relatively high, this will tie commodity prices to those of US goods; as the dollar rises in value, commodity prices will be pulled up with it. Fleisig and van Wijnbergen also find that the larger is the share of US goods in the imports of the primary-product exporter, the larger will be the deterioration in its terms of trade as a result of a dollar appreciation. This would obviously have a serious impact on countries such as Brazil, which are larger importers from the US.

In the second part of the paper the authors present empirical findings that confirm this at an aggregate level. Their results show a strong effect on the real exchange rate: a 10% real appreciation of the dollar relative to the currencies of other industrial countries leads to a 6% decline in commodity prices in terms of US goods. The results also suggest a significant downward trend of 7% a year in primary commodity prices for a given final-goods price structure. This lends support to Prebisch's 1950 hypothesis of a secular decline in real primary commodity prices. There is also a strong pro-cyclical effect: a one percentage point decrease in unemployment throughout the OECD would raise real commodity prices by 15%. Using 'Okun's Law', this suggests that a one percentage point increase in OECD output growth will lead to a 5% improvement in real commodity prices.

Fleisig and van Wijnbergen's disaggregated results are more mixed. In particular, the results do not always support the theoretical analysis, where that analysis suggests that the elasticity of the terms of trade with respect to the real exchange rate lies between zero and one. In order to isolate more clearly the effects of exchange-rate changes at a disaggregated level, the analysis may need to incorporate differences in aggregate supply conditions and relative shifts in industrial country .


Primary Commodity Prices, the Business Cycle and the Real Exchange Rate of the Dollar Heywood Fleisig
Sweder van Wijnbergen

Discussion Paper No. 90, December 1985 (IT)