Terms or Trade Volatility, Real Exchange Rate Volatility and Growth: Evidence from Commodity Terms of Trade Shocks

This paper studies the effects of terms of trade volatility on growth. First, we present a simple two-sector model where it is costly to initiate tradable goods production and terms of trade volatility decreases the labor force share of the tradables sector and GDP. Second, we show that the authorities can use international liquidity (reserves) to stabilize the real exchange rate, restore the efficient labor allocation and increase output. When we test the model using a new panel dataset, we find that, consistent with the predictions, commodity terms of trade volatility increases real exchange rate volatility and decreases GDP, but countries with large reserve holdings can prevent these effects. As expected, our results arise mainly from emerging markets and commodity exporters, where it is probably more difficult for producers to hedge their income.