Terms of trade shocks and the balance of trade: there is a Harberger-Laursen-Metzler effect

According to the Harberger-Laursen-Metzler (HLM) effect an exogenous increase in the terms of trade faced by a small open economy leads to an improvement in that country's trade balance. In this paper structural vector autoregression techniques are used to investigate whether there is any systematic pattern in the responses of the trade balance to terms of trade shocks for a large number of small open economies. Two important results emerge. First there is strong support in the data for the existence of an HLM effect. Second the response of the trade balance and real income to a terms of trade shock implied by the structural vector autoregression model are strongly consistent with those reported by Mendoza (1995) from simulating a particular dynamic stochastic equilibrium model of a small open economy. (C) 2003 Elsevier Science Ltd. All rights reserved.