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The lasting effects of terms-of-trade shocks on business cycles

The abrupt movements in commodity prices at the onset of the Covid-19 crisis have reignited policymakers’ concerns over movements in the terms of trade. The shock has certainly confirmed that terms of trade are very volatile and extremely sensitive to changes in global economic activity. This column argues that these terms of trade shocks are likely to have a persistent impact on the business cycle of developing economies, which are particularly vulnerable to fluctuations in the price of their exports.  

Developing countries are vulnerable to fluctuations in the terms of trade – the relative price of a country’s exports with respect to imports. Large swings are thought to generate abrupt changes in a country's trade balance, current account, and output. A deterioration in the terms of trade can lead to difficulties in financing current account deficits and a large external debt. The Covid-19 shock has confirmed that terms of trade are very volatile and are extremely sensitive to changes in global economic activity. This column analyses what this type of shock means for the business cycles of developing economies, which are particularly vulnerable to fluctuations in the terms of trade. 

While terms-of-trade shocks are typically viewed as a major source of business cycle fluctuations in emerging and low-income countries, existing research has not provided  clear guidance on quantifying how important they are for driving a country’s main macroeconomic variables. On the one hand, theoretical models predict that between 30-50% of the variance of output is driven by terms-of-trade shocks (Mendoza 1995, Kose 2002). On the other hand, recent empirical evidence presented in Schmitt-Grohé and Uribe (2018) suggests that terms-of-trade shocks explain around 10% of the variance of output. This has given rise to the ‘terms of trade disconnect puzzle’: terms-of-trade are less important in the data than in theory. 

Terms-of-trade shocks as world shocks

In our latest research (Di Pace et al. 2020), we revisit the ‘terms of trade disconnect puzzle’ and show that it is explained by the fact that terms-of-trade shocks are not all alike. The ‘terms of trade’ are defined as the ratio between export and import prices. As such, a ‘terms-of-trade shock’ may result from a shift in export prices, import prices, or not perfectly offsetting movements in both. 

When analysing terms-of-trade shocks, current research implicitly assumes that the economy responds symmetrically to an increase in export prices and a decline in import prices. We show that this is not the case, and document that the effects of a positive export price shock do not mirror the effects of a negative import price shock. 

Why does this happen? In developing countries, the export and import sectors are very different. These countries depend heavily on commodity exports, and exports are tightly concentrated in a few commodities. As an illustration, in half of the countries in our sample (38 developing countries), exports of three main commodities represent over 50% of a country’s total exports. By contrast, given that these countries are less diversified, their import base is less concentrated because they import a wide range of products. Therefore, it is not surprising that export price shocks have a larger impact on the economy than import price shocks. 

We disentangle three shocks that, taken together, can be interpreted as ‘world shocks’. Specifically, we identify export price, import price, and global economic activity shocks imposing economically meaningful sign restrictions on the impulse responses of a subset of variables complemented with narrative based restrictions. In order to investigate the transmission of export and import price shocks separately, we construct a comprehensive time series of country-specific export and import price indices using individual commodity and manufacturing prices combined with time-varying trade shares. Our terms of trade measure offers an improvement with respect to the official measure based on unit values derived from countries' customs data. The latter measure is likely to contain biases originated in, for example, changes in the mix of heterogeneous products or incorrect recording of quantities. Instead, our measure benefits from being directly linked to commonly observed world prices. 

Terms-of-trade shocks in the data

Figure 1 shows the impulse responses to a one standard deviation positive export price shock (blue) and a one standard deviation negative import price shock (red). We observe that an improvement in export prices leads to an increase in domestic GDP, private consumption, and investment, while the response of macroeconomic variables following an import price shock is more muted. 

Figure 1

Note: The figure shows the impulse responses to a positive one standard deviation shock in export prices (Px, blue) and negative one standard deviation shock in import prices (Pm, red) using a VAR with sign and narrative restrictions. The solid lines denote the mean response weighted by each country's size proxied by their GDP (PPP) and the dashed lines represent the 16th and 84th percentile error bands.

Figure 2 compares, for each country, the share of variance of output driven by terms-of-trade shocks (vertical axis) and driven by world shocks, captured by export price, import price, and global demand shocks (horizontal axis). It should be noted that most observations are concentrated below the 45-degree line. This indicates that world shocks explain a higher share of output fluctuations than terms-of-trade shocks, and that the ‘terms of trade disconnect puzzle’ is no longer present in the data. 

Figure 2 

Notes: The figure compares the forecast error variance decomposition (FEVD) of output, for each country, obtained estimating terms-of-trade shocks (vertical axis) vis-à-vis our model comprising export price (Px), import price (Pm) and global economic activity shocks (Yg).

Drilling deeper into the weighted average results, we find that export and import price shocks account for around 40% of output fluctuations, but export price shocks are, on average, twice as important as import price shocks for domestic business cycles. Moreover, we find that global economic activity shocks explain up to 32% of the variation in export prices and 41% of the variation in import prices (while they account for only one-fourth of the variation in the terms of trade). By moving export and import prices in the same direction, a large fraction of the impact of global economic activity shocks is canceled out in the terms of trade metric. However, they are relevant in explaining business cycles fluctuations through the asymmetric effects of export and import prices. The fact that the commodity export share is much higher than the commodity import share is key to understanding the heterogeneous results. Moreover, we find that the impact of export price fluctuations is larger for countries that rely more heavily on commodity exports. 

In summary, our finding that terms of trade matter empirically is in line with the predictions of theoretical models. The departure from a single commodity price (the terms of trade) to allow for a distinction between export and import price disturbances is important for the study of the effects of terms-of-trade shocks. Our results suggest that the large swings in commodity prices from the Covid-19 crisis will likely have a protracted negative impact on developing countries because the benefits associated with the fall in import prices are more than offset by the costs associated with lower export prices.  


Our results have a number of important implications. First, policymakers' concerns about fluctuations in the terms of trade seem to be well founded: movements in the terms of trade have substantial effects on macroeconomic variables. Second, the effects of the Covid-19 shock on commodity prices will likely cause significant scarring in developing countries. Such a negative export price shock could lead to a persistent decline in output. Third, given that a large share of developing country's business cycles is driven by world shocks, it is important that policies are implemented to mitigate the potential negative impact of these shocks. For example, a country may benefit from running a counter-cyclical fiscal policy during commodity price booms. This would be particularly important in countries with a more concentrated export base. 


Di Pace, F, L Juvenal and I Petrella (2020), “Terms-of-Trade Shocks are Not all Alike”, CEPR Discussion Paper No. DP14594. 

Kose, M A (2002), “Explaining Business Cycles in Small Open Economies: 'How Much do World Prices Matter?'”, Journal of International Economics 56: 299-327.

Mendoza, E G (1995), “The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations”, International Economic Review 36: 101-137.

Schmitt-Grohé, S and M Uribe (2018), “How Important are Terms-of-Trade Shocks?”, International Economic Review 59: 85-111.

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