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Terms of Trade Volatility and Precautionary Savings in Developing Economies

  • Salim B. Furth

This paper investigates the link between terms of trade volatility and long-term output growth in developing countries. I find that differences in terms of trade volatility account for 25% of the cross-country variation in growth from 1980 to 2007. The magnitude is arresting: a two-standard-deviation difference in terms of trade volatility between two countries is associated in the data with a 32-percentage-point difference in overall output growth. A decomposition of output growth distinguishes the dynamic effects of productivity growth from pure factor accumulation. The data show that precautionary savings in the 1970’s and 80’s took the form of high domestic investment, which was replaced in the 2000’s by investment in foreign assets. The reallocation of precautionary savings from domestic to foreign assets led to falling output in countries with volatile terms of trade. A neoclassical capital accumulation model has significant precautionary savings associated with terms of trade risk. Opening foreign bond markets in the model induces a shift away from capital and a fall in output in price-volatile countries, reproducing my finding from the data.

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Paper provided by DEGIT, Dynamics, Economic Growth, and International Trade in its series DEGIT Conference Papers with number c015_013.

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Length: 30 pages
Date of creation: Sep 2010
Date of revision:
Handle: RePEc:deg:conpap:c015_013
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  1. Blattman, Christopher & Hwang, Jason & Williamson, Jeffrey G., 2007. "Winners and losers in the commodity lottery: The impact of terms of trade growth and volatility in the Periphery 1870-1939," Journal of Development Economics, Elsevier, vol. 82(1), pages 156-179, January.
  2. Basu, Parantap & McLeod, Darryl, 1991. "Terms of trade fluctuations and economic growth in developing economies," Journal of Development Economics, Elsevier, vol. 37(1-2), pages 89-110, November.
  3. Timothy J. Kehoe & Kim J. Ruhl, 2008. "Are Shocks to the Terms of Trade Shocks to Productivity?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 804-819, October.
  4. Turnovsky, Stephen J. & Chattopadhyay, Pradip, 2003. "Volatility and growth in developing economies: some numerical results and empirical evidence," Journal of International Economics, Elsevier, vol. 59(2), pages 267-295, March.
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  7. Koren, Miklós & Tenreyro, Silvana, 2005. "Volatility and Development," CEPR Discussion Papers 5307, C.E.P.R. Discussion Papers.
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  9. Broda, Christian, 2004. "Terms of trade and exchange rate regimes in developing countries," Journal of International Economics, Elsevier, vol. 63(1), pages 31-58, May.
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  11. Lutz, Matthias, 1994. "The effects of volatility in the terms of trade on output growth: New evidence," World Development, Elsevier, vol. 22(12), pages 1959-1975, December.
  12. Paul M Romer, 1999. "Increasing Returns and Long-Run Growth," Levine's Working Paper Archive 2232, David K. Levine.
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  15. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
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