Terms of Trade Effects of Productivity Shocks and Economic Development

This paper studies the terms of trade effects from unexpected economy-specific productivity increases in both developing and advanced economies using a panel vector autoregression model with interactive fixed effects and the “max-share” approach developed by Francis et al. (2014). First, we find that the terms of trade of developing economies do not deteriorate after unexpected productivity increases and display similar dynamics to those of advanced economies. Second, studying these shocks in a more detailed classification of developing economies shows that the terms of trade worsen following an unexpected productivity increase in the least developed economies, implying that economic underdevelopment can result in unexpected productivity increases causing a deterioration in the terms of trade. However, this adverse effect of productivity increases disappears in the developing economies with some success in moving up the ladder of economic development, as implied by our finding that the terms of trade of these economies improve after an unexpected productivity increase.