RDP 9508: Are Terms of Trade Rises Inflationary? 5. Discussion and Conclusions

At the outset of the paper we posed the question: when the exchange rate floats, are rises or falls in the terms of trade inflationary? The answer is ‘it depends’. It depends on the size of the importables price effect relative to the other component effects. How then can the general case be distinguished from the specific cases? This requires estimates of the component effects of a terms of trade shock. These estimates are, however, subject to measurement errors which may be substantial.

The approach adopted in this paper has been to simulate a range of inflation outcomes from a given terms of trade shock, allowing key parameters to vary. In particular, we have focussed on the implications of different degrees of responsiveness of changes in the real exchange rate to changes in the terms of trade – that is, we have focussed on the effect of variations in δ. We have sought to identify the threshold value of δ, movement beyond which causes the inflationary effect of a terms of trade shock to change sign.

Our best guess, given reasonable estimates of the share of importables in consumption, and reasonable estimates of exchange rate pass-through, is that this threshold value of δ is about ⅓ to ½. Consequently, if movement of the real exchange rate is about half that of the terms of trade (as estimated by Gruen and Wilkinson (1991)), a rise in the terms of trade will have almost no impact on domestic inflation. Alternatively, if the real exchange rate moves almost one-for-one with the terms of trade (as estimated by Blundell-Wignall et al. (1993)), a rise in the terms of trade will put downward pressure on inflation, at least in the short run.

Importantly, though, even if the responsiveness of the real exchange rate to changes in the terms of trade is high, the absolute change in inflation is relatively small. The insulation properties of a floating exchange rate are substantial. This suggests that terms of trade shocks should not manifest themselves in disturbances to inflation of the magnitude witnessed in earlier episodes before the float.