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This study shows that the exchange rate regime adopted by developing countries plays a key role in their adjustment to fluctuations in export and import prices. Analyzing the effects of a sharp drop in export prices in seventy-five developing countries over a twenty-five year period, authors Christian Broda and Cédric Tille find that countries with a flexible exchange rate experience a much milder decline in GDP growth than those with fixed exchange rate regimes.
The authors note that developing countries rely heavily on the export of commodities and tend to be very open to foreign trade. Thus, these countries are particularly vulnerable to terms-of-trade shocks—marked changes in the price of exports relative to the price of imports. Such broad exposure to terms-of-trade fluctuations is a source of concern, the authors explain, because it can lead to increased volatility in GDP.
The authors observe that flexible exchange rates are traditionally effective in absorbing terms-of-trade shocks. If export prices decline in a country with a flexible exchange rate, for example, its currency is likely to depreciate, stimulating activity in the export sector and significantly offsetting the negative effects of the price decline on output. In countries with a fixed exchange rate, by contrast, this buffer is absent, and the adjustment to the decline in export prices must occur largely through a contraction in output.
To test this thesis, Broda and Tille assessed the effects of a 10 percent decline in the terms of trade on seventy-five developing countries in Africa, Latin America, Asia, and Eastern Europe over the 1973-98 period. They found that in countries with a fixed exchange rate, the shock led to a decline in GDP of nearly 2 percent after two years. In countries with a flexible exchange rate, however, the shock produced only a very modest contraction in GDP—about 0.2 percent. “These results,” the authors conclude, “provide strong support for the theory that a flexible exchange rate can help to insulate an economy against fluctuations in export and import prices.”
To show how forcefully fluctuations in the terms of trade will drive economic activity when the buffer provided by a flexible exchange rate is removed, Broda and Tille examine the experience of two countries with fixed exchange rate regimes, Ecuador and Argentina. Ecuador enjoyed a surge in its export prices after 2000, while Argentina faced large declines in export prices in 1998 and 1999. After controlling for other influences on the two countries’ economies, the authors find that these sharply contrasting terms-of-trade movements contributed heavily to widely divergent output performances in Ecuador and Argentina in recent years.
Christian Broda is an economist and Cédric Tille is a senior economist in the Bank’s Research and Market Analysis Group.