Income Terms of Trade Trend and Volatility in Croatia; A Growth Perspective

Abstract

In the age of globalization, both domestic and foreign factors play an important role in determining country's position on the world market, labelling that country as an open economy. Today, with few if any exceptions, all countries are open. Croatia is a small and open economy characterized with strong import dependency and external imbalances, thus any serious fluctuation on a global market can endanger its economic stability. Terms of trade as the ratio of export to import prices is an important indicator which improvement can contribute to economic stability and long-term growth. Namely, stable terms of trade facilitate efficient resource allocation and reduce inflationary pressures. While movements in terms of trade trend affect domestic purchasing power and real income, significant terms of trade shocks can lead to macroeconomic instability. This paper adds up to a growing literature on the drivers of Croatian economic growth by examining how terms of trade and its fluctuations affect the economy. Particular attention is placed on the relationship between short and long-run growth perspective and the long-run consequences of the changes in income terms of trade. Empirical modelling is based on an augmented production function and was completed with the usage of cointegration equations and parsimonious error correction models, all suggesting results that are consistent with the theory.