The Effect of Terms of Trade Shocks on GDP and the Real Exchange Rate

21/10/2018 |  Frish Roni, Polak Yinon
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The Global Economy
Abstract

 

This study finds empirical support for the hypothesis that a floating exchange rate regime moderates the effect of terms of trade shocks on real per capita GDP (hereinafter: GDP). We use a structural vector auto regression (SVAR) model to examine the effect of terms of trade shocks on GDP and the real exchange rate. The model contains three variables—the terms of trade, the real exchange rate, and real GDP. The model’s identification restrictions are based on the assumption that the terms of trade are exogenous, and that an exchange rate shock has no permanent effect on GDP. The model was estimated for 19 advanced economies and 34 developing economies between 1974 and 2015. The terms of trade shocks account for 13 to 17 percent of the GDP variance and for 15 to 18 percent of the real exchange rate variance, with no significant difference between advanced and developing economies. On average, a 5 percent shock to the terms of trade led to an increase of 0.6 percent in GDP and an increase of 2.4 percent in the real exchange rate in advanced economies, while in developing economies, it led to similar growth of GDP (0.5 percent), and a more moderate increase in the real exchange rate (1.5 percent).  The shocks to the terms of trade had a prolonged effect on GDP and on the exchange rate, thereby acting in a similar manner to supply shocks. 


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