What Can Account for Fluctuations in the Terms of Trade?

Fluctuations in the terms of trade-the price of a country's exports relative to the price of its imports-are a source of perennial concern to policymakers in developing countries and industrialized nations alike. Terms of trade growth is extremely volatile and can lead to sudden changes in a country's economic health. This paper seeks to understand the sources of fluctuations in the terms of trade. We decompose a country's terms of trade volatility into a component stemming from differences in the composition of import baskets and export baskets, which we define as a "goods price effect," and a component due to cross-country differences in the price of a particular class of goods, which we call a "country price effect". We ask whether the decomposition depends in a clear way on country characteristics-developed vs. less-developed; exporter of manufactured goods vs. exporter of fuels or other commodities? Our goal in this paper is twofold. First, we provide new evidence on the sources of terms of trade volatility that should be of use to policymakers. Second, the stylized facts that emerge from this analysis will provide guidance for economists seeking to build better models of interdependent economies.