The Structural Determinants of External Vulnerability

Abstract

This article examines empirically how domestic structural characteristics related to openness and product- and factor-market flexibility influence the impact of terms of trade shocks on aggregate output. Applying semistructural vector autoregressions to a panel of 88 countries with annual observations for the period 1974-2000, the analysis isolates and standardizes the shocks, estimates their impact on GDP, and examines how this impact depends on the domestic conditions outlined above. The article finds that greater trade openness magnifies the output impact of terms of trade shocks, particularly negative ones, while financial openness reduces their impact. Flexibility of labor and firm-entry are beneficial, with labor flexibility dampening the impact of negative shocks and ease of firm-entry magnifying positive ones only. Domestic financial depth has a more nuanced role in stabilizing the economy. Analysis of interactions across structural determinants reveals complementarities among macroeconomic conditions (trade and financial openness and depth) and, separately, among microeconomic conditions (flexibility of labor markets and ease of firm-entry). Variables across these groups tend to behave as substitutes for each other.

Keywords: F36, F41, F43