Essays on terms of trade

Abstract

This dissertation consists of three chapters. The main topic I study through them is fluctuations in terms of trade and their effects in small open economies. In particular, I study their effects in the labor and financial markets. In Chapter 1, I study the how the labor market and real GDP interact to fluctuations in the terms of trade. Conventional wisdom suggests that when terms of trade deteriorate in small open economies, real GDP decreases. In this paper, I document that the correlation between terms of trade and real GDP innovations varies widely between both positive and negative values across different countries. Furthermore, I show that this variation cannot be explained by income alone. This raises the question, why do countries' real GDPs react differently toward changes in their terms of trade? I show evidence that the way in which countries react toward changes in terms of trade is linked to the labor market. I build a real business cycle model in which a small open economy experiences terms of trade fluctuations in conjunction with real wage rigidity. I find that an economy with a real wage rigidity is able to produce either a positive or a negative correlation between terms of trade and real GDP innovations. In Chapter 2, Sora Lee and I study the relationship between terms of trade fluctuations and changes in the sovereign government interest rate spreads in emerging economies. We propose a stochastic general equilibrium model of sovereign default with endogenous default risk in order to explain the interest rate behavior in emerging economies. We incorporate two types of shocks to cover a foreign and a domestic uncertainty. We define as the domestic and the foreign uncertainty, GDP and terms of trade shock, respectively. The model is able to successfully increase the dispersion of sovereign interest rates when GDP shocks are above the trend. This result seems to suggest that terms of trade is a good candidate to explain the volatility of interest rates in small open economies when they are not under recessions or crises. In Chapter 3, I study the optimal choice of foreign issued debt incurred by a sovereign government in a small open economy. In particular, what are the shortcomings and benefits from issuing debt in a currency tightly linked to a trade partner country. I propose a two period model with uncertainty in the terms of trade and in a real exchange rate to show the benefits and costs. I find that when a government is in a deep recession, issuing debt in a currency that is not tightly linked to their trade becomes optimal.