Coping with Terms-of-Trade Shocks in Developing Countries

Christian Broda and Cédric Tille

Sharp swings in a developing country’s terms of trade—the price of its exports relative to the price

of its imports—can seriously disrupt output growth. An analysis of the effects of a decline in

export prices in seventy-five developing economies suggests that countries with a flexible exchange

rate will experience a much milder contraction in output than their counterparts with fixed

exchange rate regimes.

eveloping economies typically face large

swings in the price of the goods they

export. Such fluctuations are unwelcome

because they can contribute to increased volatility in the

growth of output (GDP). Indeed, several studies have con-

cluded that changes in the terms of trade—the price of

exports relative to the price of imports—can account for

half of the output volatility in developing countries.

In this edition of Current Issues, we examine how the

exchange rate regime affects the ability of developing

countries to absorb fluctuations in their terms of trade.

Economic theory offers a clear and widely accepted inter-

pretation of the role played by the exchange rate regime. In

a country with a flexible exchange rate, fluctuations in the

terms of trade will be offset by movements in the exchange

rate, eliminating much of the impact on economic activity.

By contrast, a country with a fixed exchange rate will expe-

rience substantial swings in output.

To test this interpretation, we observe the output effects

of a 10 percent decline in export prices in seventy-five

developing countries with differing exchange rate regimes.

We find that two years after the price decline, real GDP is

almost unaffected in countries with a flexible exchange rate,

while it drops by about 2 percent in countries with a fixed

exchange rate. These results provide strong support for the

theory that a flexible exchange rate can help to insulate an

economy against fluctuations in export and import prices.

In a separate demonstration of the importance of the

exchange rate regime, we narrow our focus to two countries

with fixed rate regimes, Ecuador and Argentina, to show

how forcefully changes in the terms of trade will drive eco-

nomic activity when the buffer of a flexible exchange rate is

absent. Ecuador benefited from higher export prices after

adopting the dollar as its currency in 2000,while Argentina

faced sharp falls in export prices during 1998 and 1999.

Our calculations indicate that the contrary movements in

the terms of trade experienced by these countries con-

tributed heavily to divergent output performances.

Why Do the Terms of Trade Matter So Much?

To understand how export and import prices affect a coun-

try’s terms of trade, consider a simple example in which a

country exports wheat and imports oil. Increases in the

price of oil represent a worsening of the terms of trade

Current Issues

IN ECONOMICS AND FINANCE

Volume 9, Number 11 November 2003

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because the country will pay more for the goods it imports.

Conversely, increases in the price of wheat boost the coun-

try’s export earnings and represent an improvement in its

terms of trade.

The terms of trade have an especially marked impact on

the economies of developing countries. One recent study

(Baxter and Kouparitsas 2000) suggests that terms-of-trade

fluctuations are twice as large in developing countries as in

developed countries. The authors attribute this pattern to the

heavy reliance of developing countries on commodity

exports, whose prices are more volatile than those of manu-

factured goods. Moreover, because developing countries

generally have a high degree of openness to foreign trade,

these sharp swings in the terms of trade affect a large share

of their economies.

Developing countries are also very exposed to terms-of-

trade fluctuations because they have little, if any, leverage

over their export prices (Broda 2003).World markets dictate

the price of the goods they export. By contrast, developed

countries and oil exporters can exert a substantial influence

on export prices. Building on the fact that terms-of-trade

shifts in developing countries are largely exogenous—that

is, determined by forces outside the countries’ control—

Mendoza (1995) and Kose (2002) find that terms-of-trade

movements can account for roughly half of the output

volatility in these countries.

Coping with Terms-of-Trade Volatility: The Role

of the Exchange Rate

Economic theory suggests that the effectiveness with which

countries cope with changes in their terms of trade—

terms-of-trade shocks—depends primarily on the nature of

their exchange rate regime. Under a fixed exchange rate

system, the value of the domestic currency is pegged to the

value of another currency or basket of currencies. Under a

flexible exchange rate regime, by contrast, the value of the

domestic currency is allowed to shift freely in response to

supply and demand conditions in the foreign exchange

market. Theory predicts that countries with flexible

exchange rate regimes will be better able to adjust to terms-

of-trade shocks.

To understand the logic behind the theory, consider the

consequences of a fall in the price of a country’s exports

under both types of regimes. At the outset, the worsening of

the terms of trade will reduce the income of the country’s

exporters,leading to a decline in activity and employment in

the export industries.

Since exporters are taking in less for-

eign currency—say, dollars—they will bring fewer dollars

to the foreign exchange market. As dollars become scarce,

fewer market participants will want to sell dollars to buy the

domestic currency—pesos in this example—and as a result,

the peso will weaken.

If the authorities in the country follow a fixed exchange

rate policy, they will be required to intervene in the foreign

exchange market to keep the value of the two currencies in

line. Thus,they will sustain the value of the peso by purchas-

ing pesos for dollars. This move will in turn drain pesos out

of the money market, reducing the amount of money and

credit available for business investment and expansion.

Because the authorities’ actions are equivalent in their

effects to a tightening of monetary policy, this response to

the decline in export prices can lead to a costly contraction

in output.

By contrast, if the authorities follow a flexible exchange

rate policy, they will refrain from intervening in the foreign

exchange market and will permit the currency to depreciate.

This depreciation makes exports more competitive in world

markets and thereby increases demand.Rising demand then

stimulates activity in the export industries, cushioning the

adverse impact of the terms-of-trade shock on output.

In sum, theory predicts that a country with a fixed

exchange rate regime will adjust to a terms-of-trade shock

through a contraction in output, while a country with a

flexible exchange rate will adjust through a currency depre-

ciation that significantly offsets the shock’s negative effects

on output. To be sure, it does not necessarily follow that a

flexible exchange rate is unambiguously the best choice for a

developing country.

Nevertheless, theory makes a com-

pelling case that a flexible exchange rate can function as a

kind of automatic stabilizer, absorbing by means of its own

movements the fluctuations in the terms of trade.

The Empirical Evidence: Is the Theory Right?

We test the theoretical prediction that a flexible exchange

rate is a superior tool for coping with terms-of-trade shocks

by looking at the experience of developing countries with

different exchange rate regimes (see Broda [2003]). Our

sample consists of seventy-five developing countries in

Africa, Latin America, Asia, and Eastern Europe, tracked

from 1973 to 1998.

We classify the exchange rate regime of each country as

either fixed or flexible, but we take into account changes

through time. We do not use the regime classifications

provided by the International Monetary Fund (IMF 1997),

because they are based on the publicly stated commitment

of the authorities in each country and may not represent the

CURRENT ISSUES IN ECONOMICS AND FINANCE VOLUME 9, NUMBER 11

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countries’ actual policies.

Rather, we adopt the classifica-

tions used in Ghosh et al. (1997), which adjust the IMF

classifications to reflect the observed behavior of the vari-

ous countries. This source shows that developing countries

have gradually moved toward more flexible exchange rate

regimes since the early 1970s (Table 1).

Using this breakdown of countries by exchange rate

regime, we assess the effects of a worsening in the terms

of trade on each country’s nominal exchange rate, real

exchange rate,

consumer prices, and real GDP.We consider a

permanent 10 percent deterioration in the terms of trade

and contrast the effects under a flexible exchange rate with

those under a fixed exchange rate. A more detailed explana-

tion of the methodology is provided in the box.

Chart 1 tracks the response of the four variables in

countries with a flexible exchange rate (blue line) and coun-

tries with a fixed exchange rate (green line) following the

worsening in the terms of trade at year 0. The responses are

computed in terms of percentage changes from the initial

situation. For example, a value of -1 indicates that the vari-

able in question is 1 percent below the level that it would

have reached had the terms of trade remained unchanged.

As expected, the worsening of the terms of trade leads to

a substantial depreciation of the domestic currency—7 per-

cent after one year—under a flexible exchange rate but has

virtually no effect under a fixed exchange rate (Chart 1, top

panel).

Although the shock leads to a contraction in GDP

under a flexible exchange rate (second panel from the top),

the decrease is relatively modest—0.2 percent after two

years—because the depreciation of the currency sustains

the competitiveness of exporters. Under a fixed exchange

rate, however, the effect on output is sharply different: here,

we observe a substantial contraction in GDP that peaks at

nearly 2 percent two years after the shock.These results bear

out the prediction that a flexible exchange rate will soften the

effects of terms-of-trade shocks relative to what the effects

would have been under a fixed exchange rate.

The impact of the terms-of-trade shock on consumer

prices also differs across exchange rate regimes (third panel

from the top). Under a flexible exchange rate, the currency

depreciation feeds into higher prices for imported goods and

leads to an increase in consumer prices of 1.7 percent after

one year. By contrast, the contraction in economic activity

under a fixed exchange rate translates into lower wages and

Tab le 1

Evolution of Exchange Rate Regimes

in Developing Countries

Number of Countries

1973 1980 1990 1998

Flexible7194253

Fixed63533122

Total70727375

Source: Broda (2003).

To test the effects of an export price decline under fixed and

flexible exchange rate regimes, we use a vector autoregres-

sion (VAR) technique representing the dynamic paths of real

GDP, the real exchange rate, consumer prices, and the terms

of trade. The system can be represented as

(1) A*Y(t) = B*Y(t-1) + C*Y(t-2)

+ D*Y(t-3) + F*Y(t-4) + e (t),

where A to F are 4 x 4 matrices of coefficients and Y is

a vector of the four endogenous variables. The system is esti-

mated using the assumption of exogenous terms of trade.

Our analysis gives the response of the variables to an exoge-

nous decline in the terms of trade. We control for a series of

factors (not included in the equation above) that can shape

the response to terms-of-trade changes, such as the degree of

openness, financial development, access to international

capital markets, and fiscal policy. For a complete description

of the empirical methodology, see Broda (2003).

The VAR methodology also allows us to assess the extent

to which fluctuations in economic variables are driven by

terms-of-trade movements. We do so by combining the

volatility of the movements and the effect of the shocks on a

given variable at a given horizon. This can be computed by

using standard variance decomposition techniques on the

VAR described above.

We offer one caveat concerning our method: our calcula-

tions assume that the choice of exchange rate regime is not

systematically correlated with other characteristics of the

economy. Two examples should illustrate the importance of

this assumption. If countries that have relatively flexible

labor markets adopt a flexible exchange rate, we may

wrongly attribute the good performance stemming from

their efficient labor markets to their flexible exchange rate.

By contrast, if countries with relatively rigid labor markets

adopt flexible regimes, we may underestimate the benefits of

a flexible exchange rate. While both cases are possible, the

current empirical literature on exchange rate regimes has not

uncovered any systematic relationship between exchange

rate regimes and structural characteristics of the economy.

Empirical Methodology

prices, with the consumer price index falling 0.4 percent

after one year. Although the higher prices under a flexible

exchange rate cushion the impact of the depreciation on the

real exchange rate, the offset is only partial and the country

experiences a real depreciation of 5.5 percent after one year

(bottom panel). The contraction in prices under a fixed

exchange rate also leads to a real depreciation, although the

magnitude—0.9 percent after one year—is much smaller.

In addition to showing that the response of the economy

to terms-of-trade shocks depends on the exchange rate

regime, our analysis provides evidence that these shocks are

a substantial source of economic fluctuations in developing

countries. Using our framework, we compute the share of

actual volatility in a variable, such as GDP growth, that can

be traced back to volatility in the terms of trade (see the box

for details). We undertake this exercise for real GDP growth,

the real exchange rate, and consumer prices, at both short

(two-year) and long (ten-year) horizons.

Under a flexible exchange rate, terms-of-trade shocks

play little role in driving GDP volatility but account for

nearly a third of the real exchange rate volatility (Table 2,

first row). By contrast, under a fixed exchange rate, these

shocks are not an important source of real exchange rate

volatility but explain between 20 and 30 percent of GDP

volatility (second row). These results further underscore

how the adjustment to shocks occurs through the exchange

rate under a flexible exchange rate and through real activity

under a fixed exchange rate.

How Output Effects Are Magnified in Fixed Regimes:

The Case of Ecuador and Argentina

The recent experience of Ecuador and Argentina shows the

crucial role of terms-of-trade shocks in driving economic

activity once the exchange rate is prevented from cushioning

the shocks’ impact on GDP growth. Until December 2001,

Argentina was under a currency board regime in which the

value of its currency was rigorously pegged one-for-one to

the U.S. dollar. Similarly, Ecuador has been using the U.S.

dollar as its currency since early 2000.

Although both countries have operated under fixed

exchange rate regimes, their growth performances in recent

years have diverged dramatically. The Ecuadorian economy

has experienced robust growth since it adopted the U.S. dol-

lar, with GDP expanding by 3.7 percent each year on average

CURRENT ISSUES IN ECONOMICS AND FINANCE VOLUME 9, NUMBER 11

Chart 1

Effects of a 10 Percent Worsening of the Terms of Trade

Nominal Exchange Rate

-2

Fixed exchange rate

Flexible exchange rate

Gross Domestic Product

-2

-1

Fixed exchange rate

Flexible exchange rate

Source: Authors’ calculations.

Note: In the top and bottom panels of the chart, a depreciation of the domestic

currency is plotted as a rise.

-3

-2

-1

Fixed exchange rate

Flexible exchange rate

Fixed exchange rate

Flexible exchange rate

543210

Consumer Price Index

Real Exchange Rate

Percentage change

Ye ar s

Tab le 2

Share of the Variance in Real GDP and the Real Exchange

Rate Driven by Terms-of-Trade Shocks

Percent

Real GDP Real Exchange Rate

Exchange Rate Regime Short-Run Long-Run Short-Run Long-Run

Flexible 2.4 9.6 28.6 31.2

Fixed 21.3 30.0 4.5 12.9

Source: Broda (2003).

Note: Short-run denotes a horizon of two years,long-run a horizon of ten years.

www.newyorkfed.org/research/current_issues 5

between 2000 and 2002 (Chart 2, top panel). By contrast, the

Argentinean economy contracted in the three years before

the collapse of the currency board, with GDP down 2.5 per-

cent each year on average between 1999 and 2001 (Chart 2,

bottom panel).

We might infer from these contrasting experiences that

the exchange rate regime has no implication for growth,

since one economy contracted and the other expanded

under a fixed rate system.However,a closer look at the actual

evolution of the terms of trade in Ecuador and Argentina,

combined with our findings from the previous section,

suggests that the fixed exchange rate played an important

role in the growth performance of these countries.

During the years in question, Ecuador and Argentina

experienced diametrically different movements in their

terms of trade (Table 3). In Ecuador, a surge in oil prices led

to an 18.0 percent improvement in the terms of trade in

2000. Although oil prices subsequently dropped,the terms of

trade did not decline as abruptly as oil prices because the

prices of other exports, such as bananas, performed well.

By contrast, Argentina saw its terms of trade worsen by

nearly 6 percent on average in 1998 and 1999. The deteriora-

tion reflected widespread weaknesses in the prices of several

exports, such as edible oils, wheat, corn, and aluminum.

Such movements in the terms of trade can affect a coun-

try’s output growth over a period of several years, as Chart 2

suggests. The ongoing impact of terms-of-trade changes

implies that a country’s growth performance in a given year

is driven by current and past changes. Thus, although the

initial fall in Argentina’s terms of trade was mostly offset in

the latter part of the period under study (with a 10.2 percent

rise in 2000), it still had a significant impact on growth.

To assess the extent to which terms-of-trade movements

account for the growth performances of Ecuador and

Argentina, we use our earlier statistical results (presented in

Chart 1) for countries with fixed exchange rate regimes,

together with the actual terms-of-trade changes experienced

by Argentina and Ecuador. Specifically, we calculate what

Ecuadorian GDP growth would have been if the only shocks

affecting the economy had been the terms-of-trade move-

ments starting in 2000.

We undertake a similar exercise for

Argentina for the 1999-2001 period.

Comparing the GDP

growth computed by our model with the actual GDP growth

of these countries enables us to quantify the contribution

of terms-of-trade shocks to the countries’ growth perfor-

mances.

Using the dynamic responses to terms-of-trade shocks

presented in Chart 1,our counterfactual exercise suggests that

movements in the terms of trade had a marked influence on

the growth performance of the two countries (Chart 2). We

estimate that in Ecuador between 2000 and 2002, improve-

ments in the terms of trade contributed an average of 1.6 per-

centage points annually to GDP growth, which averaged

Chart 2

Contribution of Changes in the Terms of Trade

to Real GDP Growth

Average annual percentage change

Ecuador: 2000-02

Sources: International Monetary Fund,

International Financial Statistics;

authors’ calculations.

-1.4

-2.5

Argentina: 1999-2001

-3

-2

-1

Contribution of changes

in the terms of trade

Real GDP growth

1.6

3.7

Tab le 3

Terms of Trade and Export Prices

Percentage Change

Ecuador

Terms of Trade Oil Bananas

1999 2.9 33.8 N.A.

2000 18.0 57.1 -1.2

2001 -6.5 -14.5 57.6

2002 7.6 1.1 25.4

Argentina

Terms of Trade Edible Oils Wheat Corn Aluminum

1998 -5.5 16.5 -23.5 -9.6 -15.8

1999 -5.9 -34.1 -4.5 -8.6 1.5

2000 10.2 -22.1 2.2 -8.6 12.4

2001 -0.6 13.0 4.9 0.7 -6.4

Sources: Banco Central de Ecuador; Instituto Nacional de Estadística y Censos

(Argentina); Chicago Board of Trade.

3.7 percent each year. By contrast, the worsening of the

Argentinean terms of trade created a drag on growth averag-

ing 1.4 percentage points each year between 1999 and 2001,

a period during which GDP fell by 2.5 percent annually.

These estimates should be viewed with some caution

since we are applying to only two countries a statistical

relation drawn from a much larger sample. Nevertheless, our

results provide persuasive evidence of the key role played by

terms-of-trade movements in determining whether output

rose or fell in Ecuador and Argentina in recent years.

Moreover, our results suggest that a fixed rate regime, in

contrast to a flexible rate regime, permits terms-of-trade

movements to exert a strong influence on output growth in

developing countries.

Conclusion

This article has explored how the exchange rate regime

adopted by developing countries can affect their ability to

adjust to terms-of-trade fluctuations. Our statistical analysis

has shown that a terms-of-trade shock will have little impact

on growth under a flexible exchange rate system because the

exchange rate’s own movements will absorb the effects of the

shock. Under a fixed exchange rate, however, this buffer is

absent and the adjustment will fall primarily on growth:

consequently, a worsening of the terms of trade will lead to a

contraction in output.

Our analysis has also shown that movements in the terms

of trade represent a sizable source of volatility for developing

countries. The contrasting experiences of Ecuador and

Argentina are a case in point: in recent years, terms-of-trade

shocks have been an important determinant of the direction

and extent of output changes in these countries.

The effectiveness of the flexible exchange rate in respond-

ing to these shocks is only one of the many considerations

that developing countries would weigh in choosing an

exchange rate regime. Nevertheless, in light of the significant

volatility risks that terms-of-trade movements pose for out-

put growth in developing countries, the consideration

appears to be an important one.

Notes

1. The studies include Mendoza (1995), Kose (2002), and Broda (2003).

2. Since Friedman’s (1953) famous case for flexible exchange rate regimes, this

argument has become one of the least disputed in favor of flexible rates.

3. Broda (2003) finds that the share explained by terms-of-trade movements

is substantially smaller. His analysis is based on empirical estimates, while the

calculations in Mendoza (1995) and Kose (2002) are based on calibrations of

their models.

4. If wages in these industries were to adjust quickly, contracting in line with

the drop in income, the terms-of-trade shock would have only a moderate

impact on activity. In practice, however, wages exhibit substantial inertia. The

failure of wages to react fast enough shifts the burden of adjustment onto the

exchange rate.

5. The magnitude of the fall in output in each exchange rate regime will

depend on the magnitude of the terms-of-trade change. However, for a given

movement in the terms of trade, the fall in output should always be larger in a

country with a fixed exchange rate regime than in a country with a flexible

regime.

6. Many considerations enter into a country’s choice of an exchange rate

regime. A full assessment of the optimal exchange rate regime is beyond the

scope of this article. Readers interested in the pros and cons of alternative

exchange rate regimes might consult Calvo and Reinhart (2000), Calvo and

Mishkin (2003), Ghosh et al.(1997), McKenzie (1999), and Tornell and Velasco

(2000).

7. Several countries classified by the International Monetary Fund as fixed

regimes experienced substantial depreciations of their exchange rate, making

them more like flexible regimes in practice. For example, El Salvador (in 1983-

84), Guatemala (in 1986-88), and Nicaragua (in 1985-87) were classified as

fixed regimes (with currencies pegged to the dollar), but their currencies

depreciated by 10 percent, 41 percent, and 106 percent, respectively. Con-

versely, several countries classified as flexible regimes—including India (in

1993-96) and Bolivia (in 1985-90)—acted more like fixed regimes when they

limited the fluctuations of their exchange rate.

8. The nominal exchange rate is the price of one country’s currency in terms of

the currency of another country—for example, the quantity of pesos required

to purchase one dollar. The real exchange rate—the nominal exchange rate

adjusted for price differences—is the price of one country’s consumption

basket in terms of the consumption basket of another country. The real

exchange rate, for example, might be understood as the quantity of Mexican

consumption baskets that one must sell in Mexico to purchase one U.S.

consumption basket in the United States. Specifically, the relation is RER =

NER * P(US) / P(Mex),where RER is the real exchange rate, NER the nominal

exchange rate, P(US) the dollar price of the U.S. consumption basket, and

P(Mex) the peso price of the Mexican consumption basket.

9. Because of the rich dynamics of the statistical model, the terms of trade

worsen by slightly more than 10 percent initially, but then ease somewhat so

that the total change is equivalent to a permanent 10 percent change.

10. Because the exchange rate is defined as units of domestic currency per unit

of foreign currency, the depreciation appears as an increase in the chart.

11. We end our analysis of Argentina in 2001 because the sharp contraction in

2002 after the collapse of the currency board stemmed primarily from the failure

of the banking sector and other factors unrelated to movements in the terms of

trade. Such factors are outside the scope of this article.

12. Oil and bananas together accounted for 59 percent of Ecuadorian exports in

2001.

CURRENT ISSUES IN ECONOMICS AND FINANCE VOLUME 9, NUMBER 11

www.newyorkfed.org/research/current_issues 7

The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal

Reserve Bank of New York or the Federal Reserve System.

About the Authors

Christian Broda is an economist and Cédric Tille a senior economist in the International Research Function of the Research

and Market Analysis Group.

13. Together, these commodities accounted for 21 percent of Argentinean

exports in 2000.

14. We ignore the pre-2000 shocks because the Ecuadorian economy was then

operating under a flexible exchange rate, so the effects of terms-of-trade move-

ments on output growth would have been limited. In any case, the terms-of-

trade movements in 1999 were not large.

15. Because of the delayed impact of the terms of trade, we consider the 1998

shock even though our analysis of growth starts in 1999.

16. Note that our method, while illustrative,is imperfect in that we infer a statis-

tical relation from a sample of countries and apply it to two particular cases.This

limitation should be borne in mind when interpreting our results.

References

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the Terms of Trade?”NBER Working Paper no.7462.

Broda, Christian. 2003. “Terms of Trade and Exchange Rate Regimes in

Developing Countries.” Journal of International Economics,forthcoming.

(See also Federal Reserve Bank of New York Staff Reports, no. 148.)

Calvo, Guillermo, and Frederic S. Mishkin. 2003.“The Mirage of Exchange Rate

Regimes for Emerging Market Countries.” NBER Working Paper no.9808.

Calvo, Guillermo, and Carmen Reinhart. 2000. “Fixing for Your Life.” NBER

Working Paper no. 8006.

Friedman, Milton. 1953.“The Case for Flexible Exchange Rates.” In Essays in

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