Terms-of-trade uncertainty and economic growth

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                               Journal of Development Economics             ECONOMICS
ELSEVIER                            Vol. 54 (1997) 323-356

       Terms-of-trade uncertainty and economic
                                 Enrique G. Mendoza *
                Department of Economics, Duke University, Durham, NC 27708, USA
                        Received 4 September 1994; accepted 18 April 1996


    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
     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
    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.
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