The Consumption Terms of Trade and Commodity Prices

The Consumption Terms of Trade and Commodity Prices Abstract: Movements in a nation's terms of trade are widely viewed as important for the understanding the sources of business cycle fluctuations, the dynamics of the trade balance and economic welfare. Backus, Kehoe and Kydland (1994) emphasize the role of productivity movements in a two-country, two-good setting. In their model an increase in domestic productivity expands output at home relative to output abroad and the terms of trade deteriorates. Put differently: a large country expanding the supply of the traded good it produces must (in equilibrium) drive down the relative price of its products on world markets. The importing country's terms of trade improves, a positive spillover. Backus and Crucini (2000) add a third region to this model; a region that specializes in oil production. When the oil region cuts back production, the relative price of oil rises, a terms of trade improvement for oil producers. Output falls in the oil importing regions because oil is an intermediate input into production of the two manufactured goods produced in those regions. The business cycle implications of this model are consistent with empirical work by Hamilton (1983) showing oil price increases in advance of U.S. recessions. Mendoza (1995) studies the terms of trade and business cycles in an extensive cross-country panel using a partial equilibrium business cycle model where terms of trade movements are exogenous. In his theoretical setting, terms of trade shocks are analogous to lotteries with the sign and magnitude of the payout dependent upon a country's pattern of specialization across an array of internationally traded goods