Terms of Trade Volatility, Business Cycles in Emerging Economies and Default Risk
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Date
2026
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Abstract
This paper examines the effects of terms of trade volatility shocks on the business cycles in emerging economies, distinguishing between common and country-specific innovations. Using a panel VAR model augmented with second moment shocks estimated with a particle filter, we find that a one-standard-deviation common volatility shock causes a fall in aggregate output and investment by 0.4% and 0.7% respectively, with domestic interest rates increasing by 0.4 percentage points. While common shocks account for 9% of output fluctuations, idiosyncratic shocks do not yield significant effects. To rationalize these outcomes, we theoretically analyze a default premium channel. Increased terms of trade volatility raises default probabilities, leading to a tighter supply of credit. By incorporating this channel into an open economy model with stochastic volatility and precautionary behavior, we reproduce the empirical contractionary responses. Finally, we demonstrate that excluding this channel leads to a counterfactual result—a negative relationship between volatility and interest rates—underscoring the importance of credit-supply behavior to understanding the effects of terms of trade volatility shifts.
Description
Tesis (Magíster en Economía)--Pontificia Universidad Católica de Chile, 2025.
Keywords
Terms of Trade Volatility, Emerging Economies, Business Cycles, Common Factors, Default Premium