Trade Openness, Investment Instability and Terms-of-Trade Volatility

In the presence of economies of scale in the investment technology, trade openness may have non-conventional effects on the level of investment, its cyclical behavior, and the volatility of the terms of trade. Trade openness may lead to boom-bust cycles of investment supported by self-fulfilling expectations. The economy may oscillate between 'optimistic' expectations, 'good' terms-of-trade and investment boom to 'pessimistic' expectations, 'bad' terms-of-trade and investment bust. We also suggest that the likelihood of such oscillations is higher for developing than for developed economies, because the former may typically incur higher setup costs of investment. This phenomenon may help to explain the excessive volatility of the terms of trade of developing countries, relative to industrial countries.