Rafael Torrealba, PUC Chile

Paper: Terms of Trade Volatility and Business Cycles in Emerging Economies

Abstract: This paper examines the effects of terms of trade volatility shocks on emerging economies business cycles, distinguishing between common and country-specific innovations. We identify common and idiosyncratic terms of trade volatility shocks using the particle filter. A one-standard-deviation common volatility shock causes a fall in aggregate output and investment by 0.3% and 0.4% respectively, with domestic interest rates increasing by 0.3 percentage points. While common shocks account for 5.5% of output fluctuations, idiosyncratic shocks do not yield significant effects. The default premium channel is key for the transmission: increased terms of trade volatility raises default probabilities, leading to a tighter supply of credit. By incorporating this channel into an open economy model with stochastic volatility, we reproduce the empirical contractionary responses. Excluding the default premium channel leads to a counterfactual result—a negative relationship between volatility and interest rates—underscoring the importance of credit-supply behavior to understanding the effects of terms of trade volatility shifts.