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Mr. Yan Carriere-Swallow, Mr. Nicolas E Magud, and Juan Yepez

. Conceptually, external adjustment to a terms-of-trade shock can take place through changes in aggregate expenditure (expenditure changing effect) or changes in its composition (expenditure switching effect). On the one hand, the expenditure changing effect reflects the reduction in purchasing power associated with persistently weaker terms of trade, leading to a compression of domestic demand and thereby of imports. On the other hand, the expenditure-switching effect responds to a change in international prices, increasing exports while shifting the composition of domestic

Mr. Yan Carriere-Swallow, Mr. Nicolas E Magud, and Juan Yepez
Theoretical models on the relationship between prices and exchange rates predict that the magnitude of expenditure switching affects the optimal choice of exchange rate regime. Focusing on the transmission of terms-of-trade shocks to domestic real variables we document that the magnitude of the expenditure switching effect is positively associated to the degree of exchange rate flexibility. Moreover, results show that flexible exchange rates allow for significant adjustment in relative prices, which in turn lowers the burden of adjustment on demand for domestic goods and, in some cases, facilitates a faster and more durable external adjustment process. These results, which are robust to accounting for possible non-linearities due to balance sheet effects or currency mismatches, shed new light on the shock absorbing properties of flexible exchange rates.