JOURNAL OF Development Journal of Development Economics ECONOMICS ELSEVIER Vol. 54 (1997) 323-356 Terms-of-trade uncertainty and economic growth Enrique G. Mendoza * Department of Economics, Duke University, Durham, NC 27708, USA Received 4 September 1994; accepted 18 April 1996 Abstract This paper examines a stochastic endogenous growth model in which terms-of-trade uncertainty affects savings and growth. The model explains the well-known positive link between growth and the mean rate of change of terms of trade, and predicts also that terms-of-trade variability affects growth. Increased terms-of-trade variability results in faster or slower growth depending on the degree of risk aversion, but in either case it reduces social welfare. These growth effects imply that welfare costs of macroeconomic uncertainty are much larger than first thought. Cross-country panel regressions provide strong support for the model's key predictions. 1997 Elsevier Science B.V. JEL classification: F41; F43 Keywords: Terms of trade; Savings; Growth; Volatility; Uncertainty I. Introduction Many recent empirical studies in growth theory have examined the nature of cross-country growth differentials and the economic forces that explain them. These studies have produced mixed statistical evidence on the contribution of macroeconomic policies or country characteristics to explain cross-country differ- * Corresponding author. T e l . : + 1-919-490-9037; fax: + 1-919-684-8974, e-mail: mendozae @econ.duke.edu 1 See, e.g., Barro (1991), Barro and Lee (1993), Barro and Sala-i-Martin (1995), Razin and Yuen (1994), Easterly and Rebelo (1993), Fischer (1993), and Easterly et al. (1993). 0304-3878/97/$17.00 1997 Elsevier Science B.V. All rights reserved. PII S 0 3 0 4 - 3 8 7 8 ( 9 7 ) 0 0 0 4 6 - l 326 E.G. Mendoza / Journal of Development Economics 54 (1997) 323-356 particularly during the 1980s. 3 Barro and Sala-i-Martin (1995) and Fischer (1993) find that country characteristics do contribute to explain growth differentials, but the terms o f trade still play a key role. Barro and Sala-i-Martin's results show that the growth effects of terms o f trade compare to those of educational attainment, public spending on education, human capital, and political instability. Fischer shows in addition that the terms of trade are more important at higher frequencies, since they are more significant in pooled than in between-means regressions. 4 While the positive relationship between terms o f trade and growth has been clearly identified, most empirical work does not conduct structural tests tied to a theoretical framework in which the role o f terms of trade is explicitly modelled. The explanatory power o f country characteristics and policy variables is related to existing growth models, whereas the terms of trade are viewed as an exogenous variable with a somewhat uninteresting role. Moreover, growth effects that could result from uncertainty and risk aversion in the presence o f terms-of-trade fluctua- tions, as well as uncertainty with regard to other growth determinants, are generally ignored. This paper attempts to shed some light on these issues by studying a model of savings under uncertainty that provides an interpretation for the observed positive relationship between average rates o f change of terms o f trade and average consumption growth rates. 5 In addition, the model highlights the importance of the variability of terms of trade as a determinant o f average growth rates, and thus illustrates potentially important growth effects of uncertainty and risk. These effects in turn have important implications for the welfare costs of macroeconomic uncertainty. The main argument that the paper makes with regard to growth effects of terms-of-trade uncertainty is a feature of growth models of varying complexity, but it remains a feature even of simple stochastic growth models. Thus, for clarity and technical simplicity, the analysis is based on a model o f a small open economy that extends the savings-under-uncertainty framework o f Phelps (1962) and Lev- h a d and Srinivasan (1969). The model can be interpreted also as a stochastic version of the one-sector endogenous growth model of Rebelo (1991). In the model, the mean and variance o f the terms o f trade determine the savings rate and 3 Pooled regressions of Easterly et al. (1993) show that if the terms of trade gain as a share of GDP rises by 1% per annum, annual growth rises by 0.42% in the 1970s and by 0.85% in the 1980s. 4 This explains why a smoothed measure of terms of trade fails to explain growth in the panels of country means of de Gregorio (1992), and suggest that the variance of terms of trade may be important for explaining growth. 5 There is a large literature on trade theory that examines the link between terms of trade and growth, as reviewed by Findlay (1984). This paper differs from the trade literature in that the link between the two variables follows from the effects of uncertainty on savings in a neoclassical setting, not from market imperfections (see, e.g., Lewis, 1954; Prebisch, 1950; Singer, 1950; and Findlay, 1980). Market imperfections are likely to be relevant for explaining growth differentials but it is also useful to determine first to what extent market forces explain the facts. E.G. Mendoza / Journal of Development Economics 54 (1997) 323-356 327 consumption growth. Growth is slower in economies in which terms of trade grow at slower rate, on average, because slow terms-of-trade growth reduces the expected real rate of return on savings--in units of imported goods--and this affects the savings rate. The variability of terms of trade also affects the savings rate and growth, with an effect that is positive or negative depending on the degree of risk aversion. If risk aversion is low, increased variability in the terms of trade, measured as a mean-preserving spread, reduces both growth and social welfare. If risk aversion is high, increased terms-of-trade variability produces faster grow but it still reduces welfare. Thus, the model predicts that the variance of the terms of trade contributes to explain growth, and hence suggests that cross-country growth regressions that include only the mean of the rate of change of terms of trade are misspecified. Given the growth effects of terms-of-trade uncertainty, the welfare gains that result from reducing consumption instability are much larger than the negligible gains estimated by Lucas (1987). Lucas's estimates, as well as similar results obtained in international real-business-cycle models (see, e.g., Backus et al., 1992; Cole and Obstfeld, 1991; and Mendoza, 1991), abstract from the possibility that altering the variance of consumption may not only affect the amplitude of consumption fluctuations around trend, but the level of that trend as well. In the savings-under-uncertainty framework, risk-averse agents adjust their savings rate, and hence the trend level of consumption, in response to changes in the variability of the underlying process driving consumption fluctuations. A similar proposition is examined in the context of the assessment of the welfare gains of international risk-sharing by Obstfeld (1994). When international diversification affects growth, the gains from risk-sharing are significantly larger than those produced by models of business cycles around exogenous trends (see, e.g., Tesar, 1995). The paper examines the empirical relevance of the model's key predictions using a multi-country database including 40 industrial and developing countries and using panel estimation methods. The model's closed-form solutions establish two hypotheses regarding consumption growth in competitive equilibrium: (a) a time-series linear relationship between the rate of change of terms of trade and consumption growth, and (b) a cross-section relationship such that country average growth rates depend on the mean and variance of the rate of change of terms of trade. These hypotheses are strongly supported by the data. In particular, there is a large adverse effect of terms-of-trade variability on economic growth, and the information captured by the variance of the terms of trade for explaining growth is not captured by the mean. These results are robust to the addition of the explanatory variables typically examined in the recent empirical growth literature (see Barro and Sala-i-Martin, 1995). The paper is organized as follows. Section 2 presents the model and conducts numerical simulations to illustrate its welfare implications. Section 3 examines cross-country regularities of growth and terms of trade, and conducts econometric tests of the model's closed-form solutions. Section 4 provides some conclusions.Download Link: