Terms of Trade and Small Open Economies Business Cycles: The role of Global Shocks

This paper proposes a new identification strategy to disentangle terms of trade movements due to global factors (global shocks) from country-specific fluctuations. This method is then applied to data on ten small open economies (SOEs) to show that global shocks contribute 33 percent of SOE business cycle. In contrast, idiosyncratic innovations account for around 80 percent of terms-of-trade volatility but are responsible for less than 10 percent of business cycle variability. The estimates suggest that developed economies are less sensitive to global shocks compared to emerging markets. The results help to reconcile current estimates on the importance of terms of trade for SOEs