Dynamic effects of terms of trade shocks: The impact on debt and growth

By specifying borrowing costs to increase with the debt to equity ratio we generate procyclical debt flows in response to terms of trade shocks, consistent with empirical evidence. Since procyclical capital flows attract unsustainably large capital inflows during favorable shocks and force countries to overadjust to adverse shocks, we obtain nonlinear adjustments, involving possible overshooting of the long-run debt level. By linking growth, procyclical debt, and terms of trade shocks, we add a distinctly dynamic component to the "Harberger-Laursen-Metzler effect". We also examine the welfare implications of the terms of trade shocks and find substantial impact of even intermediate sized shocks. (C) 2007 Elsevier Ltd. All rights reserved.