Are Terms of Trade Improvement Inflationary? : An Investigation of Non-linear Terms of Trade-Inflation Nexus in Bangladesh

Bangladesh is a lower middle income country that has followed an export-led growth strategy to develop its economy over the years which signifies the importance of Terms of Trade (TOT) movements a crucial macroeconomic tool that can dictate its volume of trade. However, despite the fact that a TOT improvement is aimed to generate positive externality on various macroeconomic indicators, it is empirically acknowledged to trigger Inflation as well, mainly through movement in the exchange rates. The aim of this paper is to fill the gap in empirical literature by investigating the linearity relationship between TOT and inflation in context of Bangladesh. In addition, this paper also looks forward to identifying the causal association between TOT and inflation in Bangladesh using annual time series data from 1980 to 2014. A multivariate model was used in which inflation was expressed as a function of TOT and other controlled variables. Augmented Dickey-Fuller test is used to determine the stationarity of the variables considered in the model. Ordinary Least Squares method is also tapped to estimate the slope coefficients attached to the independent variables in the model. Chow Break-point test and CUSUM test are applied to identify possible structural breaks in the data set. In addition, Johansen Cointegration test is employed to understand the long run associations between the variables while the Granger Causality tests provide the causal associations as well. The results confirm an inverted-U shaped non-linear relationship between TOT and inflation in Bangladesh. Moreover, the transition of the country's exchange rate regime from a fixed to the flexible framework is unable to inflict significant influence on the TOT-inflation nexus. The causality tests reveal that TOT improvement in not inflationary in the long run