THE TERMS OF TRADE, THE REAL EXCHANGE-RATE, AND ECONOMIC-FLUCTUATIONS

This paper examines the relationship between terms of trade and business cycles using a three-sector intertemporal equilibrium model and a large multi-country database. Results show that terms-of-trade shocks account for nearly 1/2 of actual GDP variability. The model explains weak correlations between net exports and terms of trade (the Harberger, Laursen, and Metzler effect), and produces large and weakly-correlated deviations from purchasing power parity and real interest rate parity. Terms-of-trade shocks cause real appreciations and positive interest differentials, although productivity shocks have opposite effects. The puzzle that welfare gains of international asset trading are negligible is left unresolved.