Academic journal article The Lahore Journal of Economics

Terms-of-Trade Volatility and Inflation in Pakistan

Academic journal article The Lahore Journal of Economics

Terms-of-Trade Volatility and Inflation in Pakistan

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The price of exports relative to the price of imports is called the terms of trade (TOT), which indicates a quantitative relationship between two products traded between two countries. An increase in the price of exports relative to that of imports indicates an improvement in the country's TOT. This means that more foreign exchange is coming into the country than going out, which has a favorable impact on the balance of payments (BOP), foreign investment, and economic growth (see Mendoza, 1995; Bleaney & Greenway, 2001; Blattman, Hwang, & Williamson, 2003). Conversely, a larger increase in the price of imports than that of exports indicates a deterioration in the TOT, which adversely affects the BOP and output growth of the country.

Any volatility in the TOT also has adverse effects on economic growth because an increase in volatility increases risk, which discourages investment by making current investment unprofitable. The TOT is more volatile in developing countries (such as Pakistan), whose exports are likely to be concentrated in primary commodities with fluctuating prices. This can, potentially, seriously disrupt the output growth of these countries (Broda & Tille, 2003). Mendoza (1995), for instance, shows that TOT volatility accounts for up to half of the output volatility in developing countries.

Other than output, TOT volatility is also considered a major source of inflation fluctuations (volatility) in developing countries. Theoretically, the TOT can affect inflation both positively and negatively. Under a fixed exchange rate system, the literature posits a positive relationship between TOT shocks and inflation; under a flexible exchange rate system, this relationship is reversed, at least in the short run (Gruen & Shuetrim, 1994; Gruen & Dwyer, 1995; Andrews & Rees, 2009).

Under a floating exchange rate system, a rise in the TOT leads to nominal and real exchange rate appreciation, which have a favorable impact on inflation. Gruen and Shuetrim (1994) have established a "threshold" exchange rate response: if the rise in the real exchange rate is less than this threshold, then the rise in TOT will increase inflation. Conversely, if the currency appreciates more than this threshold, an increase in TOT will decrease domestic inflation. Further, high volatility in the TOT increases uncertainty, which causes investment and thereby aggregate demand to fall. This, in turn, reduces domestic inflation (Desormeaux, García, & Soto, 2010). A decrease in investment will also reduce the demand for and hence wages of labor. It will decrease the cost of production, leading to lower price levels, i.e., domestic inflation will fall.

As in the theoretical literature, empirical studies also present contradictory views on the effect of TOT shocks on the inflation rate. Some show that a rise in TOT is inflationary (see Durevall & Ndung'u, 1999; Hove, Mama, & Tchana, 2012). Most studies, however, conclude that, under a fixed exchange rate, a rise in TOT is inflationary whereas a fall in TOT reduces inflation; under a floating exchange rate, this effect is reversed (see Gruen & Shuetrim, 1994; Jääskelä & Smith, 2011).

Broda (2004) also concludes that negative TOT shocks are deflationary under a peg and inflationary under a floating rate. In the first case, the observed real depreciation is small and slow in response to a fall in TOT; consequently, domestic inflation falls. Under a floating rate, the real depreciation is large in response to a fall in TOT; consequently, domestic inflation rises. The results confirm a negative relationship between TOT shocks and the inflation rate under a flexible exchange rate system.

Other studies, however, show that TOT volatility has a negative effect on inflation and that a higher TOT is not always inflationary (Gruen & Dwyer, 1995). This implies that the situation is still unclear. …

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