Modelling terms of trade volatility impact on output dynamics in Russia

In this paper, we analyze terms of trade volatility impact on macroeconomic dynamics in the dynamic stochastic general equilibrium (DSGE) model for the Russian economy. The question of volatility impact on the Russian economy is still uncovered in modern literature. It hasn’t been studied in the context of DSGE models yet. First, we build an aggregate index of terms of trade volatility which takes into account export components share as well as their dynamics through past years. This index is interpreted as uncertainty measure of external economic conditions for our country. We present methodology of constructing volatility index with a help of stochastic volatility model (SV model) and estimate it with particle filter. SV model shows that 2009 and 2014-2015 years experienced the highest volatility picks for the last fifteen years. Second, we explain why SV is suitable for DSGE modelling. Third, we integrate terms of trade volatility index in small open economy DSGE model. In order to estimate uncertainty impact we build two-sector DSGE model with exogenous terms of trade volatility shocks and four types of home economic agents: households, export-oriented firms, firms producing intermediate goods and firms producing final goods aggregating import and domestic intermediate goods. It is worth noting that volatility impact shocks consideration requires approximation of nonlinear DSGE model around steady state up to third order. small open economy, two-sector DSGE model, stochastic volatility model, terms of trade According to the results time-varying terms of trade volatility plays an important role in business cycles of the Russian economy. A sharp volatility increase leads to output and consumption shrinkage which is supported by recent 2014-2015 crisis.