Terms of Trade in Small Open Economies : The Role of Monopolistic Output Markets

This paper revisits the role of terms of trade using a small open economy (SOE) model in which imports are inputs in production, output markets are imperfectly competitive and firms are connected in an input-output network. Otherwise, the model nests the standard SOE model commonly used in quantitative macro. Using this framework, this paper delivers the following results: (i) terms of trade shocks affect TFP in the same way as in the data, (ii) terms of trade shocks increase the volatility of consumption relative to that of output, and (iii) input-output linkages amplify the influence of terms of trade on the real economy. The model is calibrated to Mexico. Numerical experiments show that terms of trade shocks alone account for about half of observed TFP volatility and approximately 45 percent of the observed output volatility. With respect to the excess volatility of consumption, terms of trade shocks imply a volatility of consumption that is 54 percent larger than the volatility of output. Plugging productivity and terms of trade shocks into the model generates a consumption volatility that is 5 percent more than that of output, close to the actual ratio of volatilities in the data