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The Terms of Trade as Drivers of Economic Fluctuations in Developing Economies: An Empirical Study

Paul Castillo () and Jorge Salas ()

in Premio de Banca Central Rodrigo Gómez / Central Banking Award "Rodrigo Gómez" from Centro de Estudios Monetarios Latinoamericanos, CEMLA

Abstract: We use quarterly data from Peru to examine the empirical relationship between permanent terms-of-trade shocks and economic fluctuations in developing small open economies. To do this, we estimate a VAR model with common stochastic trends, following the methodology described in King et al. (1991) and Mellander et al. (1992). Our main finding is that permanent terms-of-trade shocks account for the largest share of output, consumption, and investment long-run fluctuations. This result is robust across alternative specifications. Moreover, we show that the variability of potential output growth, as measured through the estimated permanent component of GDP, is highly dependent on the terms of trade swings. Our main results remain unchanged when we estimate the model with data from Chile, although in this case the influence of permanent domestic productivity shocks appears to be more significant than in the Peruvian model.

Keywords: Economic fluctuations; Terms of trade; Small open economy; Common trends (search for similar items in EconPapers)
JEL-codes: E31 E32 (search for similar items in EconPapers)
Date: 2010
ISBN: 978-607-7734-37-6
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