Terms of Trade Shocks and Macroeconomic Performance. Evidence from Ecowas Member States

TABLE OF CONTENTS

LIST OF FIGURES

LIST OF TABLES

Abstract

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
1.2 Statement of the Problem
1.3 Research Questions
1.4 Objectives of the Study
1.5 Research Hypotheses:
1.6 Significance of the Study
1.7 Scope and Limitation of Study

CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.1 Preamble
2.2 Theoretical Literature Review
2.3 Empirical Literature Review
2.4 Justification of Study

CHAPTER THREE
RESEARCH METHOD
3.1 Preamble
3.2 Theoretical Framework
3.3 Model Specification
3.4 Estimation Technique and Procedure
3.5 Evaluation of Estimates
3.6 Test of Research Hypotheses
3.7 Nature and Source of Data

CHAPTER FOUR
DATA PRESENTATION, ANALYSES AND DISCUSSION OF FINDINGS
4.1 Preamble
4.2 Data Presentation
4.3 Data Analysis
4.4 Evaluation of Estimates/Research Hypotheses
4.5 Discussion of Findings

CHAPTER FIVE
SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS
5.1 Preamble
5.2 Summary of Findings
5.3 Conclusion
5.4 Recommendations
5.5 Contributions of the Study to Knowledge

REFERENCES

APPENDIX

LIST OF FIGURES

Figure 1.1: Time series plot merchandise terms of trade from 1990 to 2015

Figure 1.2: Terms of trade shock and aggregate economic behaviour

Figure 4.1: Inverse Roots of AR Characteristic Polynomial

Figure 4.2: The IRF of Macroeconomic variables to TOTS in ECOWAS

Figure 4.3: The IRF of TOTS to Macroeconomic variables in ECOWAS

Figure 4.4: The IRF of Macroeconomic variables to TOTS and vice versa in WAMZ

Figure 4.5: The IRF of Macroeconomic variables to TOTS and vice versa in WAEMU

Figure 4.6: VDC of Macroeconomic variables to TOTS in ECOWAS, WAMZ and WAEMU

Figure 4.7: VDC of TOTS to Macroeconomic variables in ECOWAS, WAMZ and WAEMU

LIST OF TABLES

Table 1.1: Terms of trade shocks in twelve ECOWAS selected countries

Table 2.1: Tabular Summary of Empirical Literature

Table 4.1: Summary of PVAR estimates

Table 4.2: Summary of a priori expectation

Table 4. 3: Summary of Confidence interval

Table 4. 4: Summary of Confidence interval approach to hypothesis testing

Abstract

The trend and impact of terms of trade shocks on the overall macroeconomic behaviour have been a recurring issue in the open market economy and have strong implication in designing and implementing development strategies and policies. There has been a growing research programme examining the link between domestic economic activity and trade shocks. Some studies conclude that trade shocks play an important role in driving macroeconomic fluctuations. Others find that trade disturbances account for only a small fraction of the variation in output. Recognizing the existing literature, this current study extends the frontier of the knowledge on the nexus between terms of trade and macroeconomic performance by examining the impact of terms of trade shocks on macroeconomic performance in ECOWAS generally and in WAMZ and WAEMU using a panel vector autoregressive (PVAR) model. ECOWAS economy has been plagued by twin problems of adverse terms of trade shock and poor macroeconomic environment. What does this scenario portend for African economy in general and the ECOWAS sub-region in particular, since terms of trade is one of the most important relative prices in economics? This study, therefore examined the effects of terms of trade shock on the macroeconomic performance in ECOWAS on one hand and the reversed effect of these macroeconomic variables on terms of trade shocks. In line with our objectives, four research hypotheses were test. We decomposed the ECOWAS economy into two financial blocs (West Africa Monetary Zone and West Africa Economic and Monetary Union), and then assessed the responsiveness of macroeconomic variables to terms of trade shock in these blocs; and also the responsiveness of terms of trade shock to a unit shock in macroeconomic variables. The study adopted the restricted PVAR model with application of impulse response analysis and variance decomposition test and covers the period from 1990 to 2015. Other techniques of analyses used include: Descriptive statistics (univariate and panel), univariate and panel unit root test, panel cointegration test etc. The findings indicate that terms of trade shock have significant economic effect on macroeconomic performance in ECOWAS, WAMZ and WAEMU; the findings also reveal that macroeconomic indicators (gross domestic product growth, inflation, money supply growth and real exchange rate) have impact on terms of trade shock in these areas. The study therefore, recommends among other things that export competitiveness be pursued by the authority by instituting suitable monetary policy that will push up import price thereby reducing oversea demand.

CHAPTER ONE INTRODUCTION

1.1 Background to the Study

Economic Community of West African States (ECOWAS) is a regional trade area in West Africa formally established in May 1975 by the ECOWAS Treaty. The Treaty was revised in 1993, to accelerate the process of integration and establish an economic and monetary union to stimulate economic growth and development in West Africa. Objectives of the treaty include: the removal of customs duties for intra-ECOWAS trade and taxes having equivalent effect; the establishment of a common external tariff; the harmonization of economic and financial policies; and the creation of a single monetary zone. ECOWAS currently has a regional grouping of fifteen countries (following the withdrawal of Mauritania in 1999) and population of about 355 million with a dominant Nigerian economy, accounting for half of the population and half of the regional aggregate GDP. Beginning in 1998, the economic performance of the region as a whole has weakened, primarily because of a sharp decline in the terms of trade (-3.3% in 1999), and political uncertainties in several countries, notably Côte d'Ivoire. Growth resumed since 2000 with a growth rate of 2.6% and 3.5% in 2001. The sub regions’ real Gross Domestic Product (GDP) growth is projected to hit 7.1 percent in 2015 as against 6.3 percent in 2014 (World Bank, 2013; Mahama, 2015).

Basically, there are two dominant blocs in the region: the West Africa Monetary Zone (WAMZ) which consists of Gambia, Ghana, Guinea, Nigeria and Sierra Leone. And the West Africa Economic and Monetary Union (WAEMU) comprising of Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal and Togo. Others are Liberia and Cape Verde.

ECOWAS economy like every modern regional economy has a good level of trade openness, with major trading partners consisting of mostly industrialized economies of the world. Its exports basket is made up of limited range of agricultural commodities and mineral resources, commonly known as primary commodities. The import basket on the other handed is made up of wide range of finished goods. The volumes of its imports far outweigh the exports volume. Again, over reliance on internationally traded commodities leaves ECOWAS countries, and consequently ECOWAS economy vulnerable to external shocks of international market price fluctuations. Manufactured exports are negligible. Intra-regional trade as a share of total trade remains marginal, at some 10 percent reflecting the lack of complementarities of the economies (World Bank, 2013; Mahama, 2015). These peculiarities of this region have over time dictated the pace and direction of the behaviour of its terms of trade.

Terms of trade is an important determinant of the performance of an open economy. It is the ratio of the prices of a country’s exports to the prices of its imports. It is a net barter terms of trade, which measures the number of units of imports that can be exchanged for a unit of exports. In other words, terms of trade is the price of exports relative to the price of imports. It indicates a quantitative relationship between two products traded between two countries. An increase in the price of exports relative to that of imports indicates an improvement in the country’s terms of trade. Being a price, terms of trade like most macroeconomic indicators, is characterised by swings.

These swings in terms of trades of ECOWAS member states and the consequent effects on ECOWAS region have significant implications for the African economy both in the medium term and in the longer term. These swings occasion a number of challenges, especially for inflation targeting central banks. ECOWAS region and indeed all the African economies have been variously classified as developing economies. This is evidenced by the fact that they export majorly primary commodities and import industrial commodities. And the debate over trends in the terms of trade between primary commodities and industrial commodities, their causes and their impact has dominated the Literature for more than a century.

Classical economists posit that the terms of trade of primary commodities exporting economies should improve over time since land and natural resources are in inelastic supply. But evidence from the data for twelve selected primary commodities exporting economies from ECOWAS sub-region does not completely support the view held by the classical economists.

Figure 1.1: Respective ECOWAS Member States’ Merchandise Terms of Trade from 1990 to 2015.

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Source: generated by the researchers based on data from the global economy, (2016).

Figure 1.1: Respective ECOWAS Member States’ Merchandise Terms of Trade from 1990 to 2015 cont’d.

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Source: generated by the researchers based on data from the global economy, (2016).

One obvious feature of terms of trades of each of the twelve selected countries, and by extension ECOWAS, WAMZ and WAEMU is that there have been periods of cyclical booms and depression as indicated by the wave-like fluctuations. It is clear that there have been periods over time when the terms of trades have changed considerably from both a trend and volatility perspective. The movements in the merchandise terms of trade of these selected ECOWAS countries have not followed the same pattern over time. While some countries (Benin, Burkina-Faso, Cote D’ Ivore, Cape Verde, Ghana, Mali, Niger and Nigeria) are characterised by increasing terms of trade, others (Gambia, Guinea-Bissau, Senegal and Togo) have had declining terms of trade during these periods.

What does this portend for African economy in general and the ECOWAS sub-region in particular, since terms of trade is one of the most important relative prices in economics? According to Cashin and Pattillo (2000), the movement in the terms of trade of commodity-exporting developing countries of Sub-Saharan African is a key determinant of macroeconomic performance and has an important impact on real national incomes. Ezema and Amakom (2011) posit that this movement in terms of trade results in terms of trade shocks which is a major source of distortion and has stunted growth in these economies. From the views above, the conclusion that adverse terms of trade shocks is prevalent in ECOWAS countries emerges. But what do the data say?

Table 1.1: A table showing the terms of trade shocks in twelve ECOWAS selected countries on a five period average except the last column (2010-2015). The values are expressed in percentage (%).

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Source: the researcher’s computation based on data from the global economy, (2016).

Positive value represents positive shock while negative value represents adverse terms of trade shocks. Countries like Cape Verde and Gambia recorded zero terms of trade shocks on a five period average (1990 to 1994) with average of 0% per annum. While Burkina Faso recorded positive terms of trade shock of 1.81% on a five period moving sum, averaging about 0.36% per annum, the remaining countries (Benin; Côte d’Ivoire; Ghana; Guinea-Bissau; Mali; Niger; Nigeria; Senegal and Togo) recorded adverse terms of trade shocks, with countries like: Côte d’Ivoire and Niger reaching all time high adverse terms of trade shocks of -75.99% and -47.43% on a five period moving sum, with the average of -15.20% and -9.49% per annum respectively.

During the same period (1990 – 1994), ECOWAS recorded -304.10% terms of trade shocks with average of -5.05% per annum. Disaggregating the ECOWAS value into WAEMU and WAMZ financial blocks, suggests that WAEMU recorded -257.54% terms of trade shocks with the average of about -6.44% per annum, while WAMZ recorded -46.55% with average of about -2.33% per annum. A look at the last two columns of table 1.2 (2005 – 2015), shows that there are some improvements in the terms of trade of ECOWAS countries. Despite this improvement, it is clear that terms of trade shocks are real in ECOWAS countries.

Again we show the trends in terms of trade shocks and aggregate economic behaviour for the twelve selected ECOWAS countries for the period 1990 to 2015. This is shown in the following graphs.

Figure 1.2: Terms of Trade shock and aggregate economic behaviour for ECOWAS member countries from 1990 to 2015.

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Source: generated by the researchers based on data from the global economy, (2016).

The above graphs indicate there are large and persistent fluctuations in terms-of-trade shocks, GDP growth, inflation and money supply growth, somewhat similar to that of terms of trade as presented in figure 1.1. This evidence tends to suggest that terms of trade is procyclical. Hence, building on other previous studies, this study adopts a bi-directional approach to investigate the interactions of cyclical fluctuations in ECOWAS. Specifically, we examine the impact of terms of trade shocks on macroeconomic indicators (GDP growth, inflation rate, money supply growth and relative exchange rate) and in turn investigate the impact of these indicators on terms of trade shocks using panel vector autoregressive (PVAR) framework. This is necessary because it does appear that cyclical fluctuations tend to be procyclical.

1.2 Statement of the Problem

The trend and impact of terms of trade shocks on the overall macroeconomic behaviour have been a recurrent issue in the open market economy. This has posed a host of macroeconomic challenges in the design and implementation of development strategies and policies, especially in the developing countries. Terms of trade shocks are important determinants of the performance of open economies. And economies that have low (or no) level of degree of openness may have little (or no) worry about the trend and impacts of terms of trade shocks on the macroeconomic behaviour. But there is rarely any economy that is closed in modern market economy; every economy has some good degrees of trade openness. Hence, terms of trade shocks are phenomena that are common to both developed and developing economies.

ECOWAS countries have high level of trade openness. But the problem with these countries in particular and ECOWAS in general is not only that of level/degree of trade openness, the line of products traded by these countries in the international market is another issue. In general ECOWAS export baskets are comprised of majorly primary commodities and import baskets of finished (or industrial) goods. These two lines of commodities have their distinct characteristics, for instance, while primary commodities have elastic demand, the demand for industrial or finished products is inelastic. Again, the prices of primary commodities are highly volatile, compared to the prices of industrial or finished products. These volatilities in the world prices of the primary commodities have occasioned negative terms of trade shocks. The problem is compounded considering the fact that primary commodities exporters (mostly developing countries) are price takers compared to developed economies that can influence the prices of finished products in the world market.

It is also a truism that ECOWAS does not have (a well developed) market for most of its primary commodities and still depend heavily on imported industrial products for its manufacturing; hence, what happens in the world market influences the overall behaviour of the domestic economy. It is these gaps generated by demand-supply interplay that occasion weak domestic macroeconomic environment, as some key macroeconomic indicators, such as exchange rate and inflation are mostly affected.

These evidences are well documented on the background of the study where we show statistically that terms of trade shocks are real in most of the ECOWAS states, and in the two financial blocs (WAMZ and WAENU) and by extension in ECOWAS region, and also the trends of aggregate macroeconomic behaviour in the region have been fluctuating. Though, some macroeconomic indicators seem resilience in the region, the region on the whole has been plagued by a twin problem of adverse terms of trade shocks and poor/weak macroeconomic environment. These dual and concurrent problems call into question, the nexus between terms of trade shocks and macroeconomic performance in ECOWAS, WAMZ and WAEMU. These puzzling issues give rise to the research questions presented in the following section.

1.3 Research Questions

Based on the foregoing problems, the following questions guided the conduct of this research work:

1. Do terms of trade shocks have any impact on the macroeconomic performance of ECOWAS economy?
2. Do macroeconomic variables have any impact on the terms of trade shock in ECOWAS economy?
3. Do macroeconomic variables respond to terms of trade shocks in WAMZ and WAEMU economies?
4. Do terms of trade shocks respond to macroeconomic variables in WAMZ and WAEMU economies?

1.4 Objectives of the Study

The main objective of this study is to assess the performance of ECOWAS economy amidst persistence terms of trade shock. Other specific objectives include:

1. To assess the impact of terms of trade shocks on the macroeconomic performance in ECOWAS economy.
2. To assess the impact of macroeconomic variables on terms of trade shocks in ECOWAS economy.
3. To investigate the responses of macroeconomic variables to terms of trade shocks in WAMZ and WAEMU economies.
4. To characterise the response of terms of trade shocks to fluctuation in macroeconomic variables in WAMZ and WAEMU economies.

1.5 Research Hypotheses:

In attempt to achieve the above objectives, three research hypotheses are tested. These hypotheses are stated in the alternatives as follow:

1. Terms of trade shocks have significant impact on macroeconomic performances in ECOWAS economy.
2. Macroeconomic variables have significant impact on terms of trade shocks in ECOWAS economy.
3. Macroeconomic variables are responsive to terms of trade shocks in WAMZ and WAEMU economies.
4. Terms of trade shocks are responsive to fluctuation in macroeconomic variables in WAMZ and WAEMU economies.

1.6 Significance of the Study

The findings of the study, will suggest what measures needed to be taken into consideration in order to improve the performance of macroeconomic activity in ECOWAS, and in each of the two financial blocs of WAMZ and WAEMU. This is because of the unusual increase of trend in exchange rate and inflation fluctuations that have hampered overall economic activities in these areas.

Thus, the understanding of the linkages between terms of trade shocks and macroeconomic performance will assist government and/or private practitioners in designing policy thrust that will promote investment opportunities, improve fiscal balance and current account balance, reduce income poverty and poor livelihoods.

Again, the knowledge of the degree to which terms of trade shocks affect macro-economic activities in each of the twelve countries, the ECOWAS sub-region and the two financial blocks, will aid policy makers in the design of trade and macro-economic policies.

The application of the findings of this study can help improve living standards of the citizens of these countries through improved macroeconomic performances. Again, the outcome of the study can provide additional resources for further research.

1.7 Scope and Limitation of Study

The study is on the impact of terms of trade shocks on macroeconomic performance in ECOWAS for the period 1990 – 2015. The choice of the start data is based on the data availability. The study centres on ECOWAS region and takes into cognizance the peculiarities of each member country and presence of two monetary unions (WAMZ and WAEMU) in ECOWAS region. The study is limited to the following twelve West African countries: Benin (BJ), Burkina-Faso (BF), Côte d’Ivoire (CIV), Cape Verde (CV), the Gambia (GM), Ghana (GH), Guinea-Bissau (GW), Mali (ML), Niger (NE), Nigeria (NG), Senegal (SE) and Togo (TG). The other ECOWAS countries (Guinea; Liberia and Sierra Leone) are not included in the sample, because too many data are missing. The major limitation of this study is data availability.

CHAPTER TWO REVIEW OF RELATED LITERATURE

2.1 Preamble

The essence of literature review is to help clarify the thoughts about the topic. It is a way of knowing what others have done, what gaps exist and how the current study intends to fill those gaps. The review of literature links the work to be undertaken with the existing knowledge. This literature review starts with the conceptualization of the key terms, followed by basic theories and other theoretical issues. We then present the empirical literature, the summary of empirical literature and the justification of the study.

2.2 Theoretical Literature Review

2.2.1 Conceptual Issues

It is necessary that the key concepts in this study be explained so that one gets a clear understanding of the whole subject. These important concepts which are of value in this study are: terms of trade, terms of trade shocks and macroeconomic performance.

1. Terms of trade:

Terms of trade is the ratio of the prices of a country's exports to the prices of its imports. It measures the number of units of imports that can be exchanged for a unit of exports. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods. Changes in the terms of trade have an especially strong impact on the macroeconomic performance and incomes of commodity-exporting developing countries.

In the more realistic case of many products exchanged between many countries, terms of trade can be calculated using a Laspeyres Index. In this case, a nation's terms of trade is the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports. The Laspeyre export index is the current value of the base period exports divided by the base period value of the base period exports. Similarly, the Laspeyres import index is the current value of the base period imports divided by the base period value of the base period imports.

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Basically, export price over import price times 100 gives the TOT value.

If the percentage is over 100% then the home economy is doing well (Capital Accumulation). If the percentage is under 100% then the home economy is not going well (More money going out than coming in, i.e. capital flight).

If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports.

If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

2. Terms of trade shocks:

Terms of trade shocks are the differences between country’s export and import. Terms of trade shocks are fiscal shocks. They are important determinants of the performance of open economies. Terms of trade shocks are the gaps between import effects and export effects. This, according to McCarthy, Neary and Zanalda (1994) is expressed as:

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Where

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In the McCarthy, Neary and Zanalda (1994) framework, a positive value for TOT represents an adverse shock while a negative value represents a favorable shock. On the other hand, terms of trade volatility is measured as the standard deviation of terms of trade growth.

3. Macroeconomic performance:

Macroeconomic performance refers to an assessment of how well a country is doing in reaching key objectives of government policy. The main aim of policy is usually an improvement in the real standard of living for their population. The term ‘real’ means that we have taken into account the effects of rising prices so that we get a better picture of how many goods and services we can afford to buy and consume.

The performance of an economy is usually assessed in terms of the achievement of economic objectives. These objectives can be long term, such as sustainable growth and development, or short term, such as the stabilization of the economy in response to sudden and unpredictable events, called economic shocks.

To know how well an economy is performing against these objectives, economists employ a wide range of economic indicators . Economic indicators measure macro-economic variables that directly or indirectly enable economists to judge whether economic performance has improved or deteriorated. Tracking these indicators is especially valuable to policy makers, both in terms of assessing whether to intervene and whether the intervention has worked or not. Some of these indicators that are used in this study include: Gross Domestic Product (GDP), Inflation, terms of trade (shocks), exchange rate and money supply growth.

2.2.2. Review of Basic Theories

The performance of every economy depends on the level of business cycle/trade ostensibly present. In the era of persistent cyclical depressions, the overall macroeconomic fundamentals tend to suffer. This presupposes that business cycle can trigger further cycle; this study therefore, is situated within the context of business cycle theory. Several theories of business cycles have been propounded from time to time. Each of these theories spells out the factors which cause business cycles. Before examining the modern theories of business cycles we first review earlier theories of business cycles, since they also contain important elements whose study is essential for proper understanding of the causes of business cycles.

1. Hawtry’s Monetary Theory of Business Cycle

The monetary theory of business cycles is an old theory propounded by Hawtrey. This theory explains the behaviour of economy which is under gold standard. Economy is said be under gold standard when either money in circulation consists of gold coins or when paper notes are fully backed by gold reserves in the banking system.

According to Hawtrey, increases in the quantity of money raises the availability of bank credit for investment. Thus, by increasing the supply of credit expansion in money supply causes rate of interest to fall. The lower rate of interest induces businessmen to borrow more for investment in capital goods and also for investment in keeping more inventories of goods. Thus Hawtrey argues that lower rate of interest will lead to the expansion of goods and services as a result of more investment in capital goods and inventories. Higher output, income and employment caused by more investment induce more spending on consumer goods.

Thus, as a result of more investment made possible by increased supply of bank credit economy moves into the expansion phase. The process of expansion continues for some time. Increases in ag­gregate demand brought about by more investment also cause prices to rise. Rising prices lead to the increase in output in two ways.

First, when prices begin to raise businessmen think they would raise further which induces them to invest more and produce more because prospects of making profits increase with the rise in prices. Secondly, the rising prices reduce the real value of idle money balances with the people, this rising prices which induces them to spend more on goods and services. In this way rising prices sustain expansion for some time.

However, according to Hawtrey, the expansion process must end. He argued that rise in incomes during the expansion phase induces more expenditure on domestically produced goods as well as more on imports of foreign goods. He further assumes that domestic output and income expand faster than foreign output.

As a result, imports of a country increase more than its exports causing trade deficit with other countries. If exchange rate remains fixed, trade deficit means there will be outflow of gold to settle its balance of payments deficit. Since the country is on gold standard, outflow of gold will cause reduction in money supply in the economy.

The decrease in money supply will reduce the availability of bank credit. Reduction in the supply of bank credit will cause the rate of interest to rise. Rising interest rate will reduce investment in physical capital goods. Reduction in investment will cause the process of contraction to set in.

As a result of reduced order for inventories, producers will cut production which will lower income and consumption of goods and services. In this state of reduced demand for goods and services, prices of goods will fall. Once the prices begin to fall businessmen begin to expect that they will fall further. In response to it traders will cut order of goods still causing further fall in output.

The fall in prices also causes real value of money balances to rise which induce people to hold larger money holdings with them. In this way contraction process gathers momentum as demand for goods start declining faster and with this economy plunges into depression.

But after a lapse of sometime depression will also come to an end and the economy will start to recover. This happens because in the contraction process imports fall drastically due to decrease in income and consumption of households, whereas exports do not fall much.

As a result, trade surplus emerges which causes inflow of gold. The inflow of gold would lead to the expansion of money supply and consequently availability of bank credit for investment will increase. With this, the economy will recover from depression and move into the expansion phase. Thus, the cycle is complete. The process, according to Hawtrey, will go on being repeated regularly.

2. Under-Consumption Theory

Under-consumption theory of business cycles is a very old one which dates back to the 1930s. Malthus and Sismodi criticized Say’s Law which states ‘supply creates its own demand’ and argued that consumption of goods and services could be too small to generate sufficient demand for goods and services produced. They attribute over-production of goods due to lack of consumption demand for them. This over-production causes piling up of inventories of goods which results in recession.

Under-consumption theory as propounded by Sismodi and Hobson was not a theory of recurring business cycles. They made an attempt to explain how a free enterprise economy could enter a long-run economic slowdown.

A crucial aspect of Sismodi and Hobson’s under-consump­tion theory is the distinction they made between the rich and the poor. According to them, the rich sections in the society receive a large part of their income from returns on financial assets and real property owned by them.

Further, they assume that the rich have a large propensity to save, that is, they save a relatively large proportion of their income and therefore, consume a relatively smaller proportion of their income. On the other hand, less well-off people in a society obtain most of their income from work, that is, wages from labour and have a lower propensity to save.

Therefore, these less well-off people spend a relatively less proportion of their income consumer goods and services. In their theory, they further assume that during the expansion process, the incomes of the rich people increase relatively more than the wage-income.

Thus, during the expansion phase, income distribution changes in favour of the rich with the result that average propensity to save falls, that is, in the expansion process saving increases and therefore consumption demand declines.

According to Sismodi and Hobson, increase in saving during the expansion phase leads to more investment expenditure on capital goods and after some time lag, the greater stock of capital goods enables the economy to produce more consumer goods and services.

But since society’s propensity to consume continues to fall, consumption demand is not enough to absorb the increased production of consumer goods. In this way, lack of demand for consumer goods or what is called under-consumption emerges in the economy which halts the expansion of the economy.

Further, since supply or production of goods increases relatively more as compared to the consumption demand for them, the prices fall. Prices continue falling and go even below the average cost of production bring losses to the business firms. Thus, when under-consumption appears, production of goods becomes unprofitable. Firms cut their production resulting in re­cession or contraction in economic activity.

3. Samuelson’s Model of Multiplier Accelerator Interaction

The economists of post-Keynesian period emphasized the need of both multiplier and accelerator concepts to explain business cycles. Samuelson’s model of multiplier accelerator interaction was the first model that represents interaction between these two concepts. In his model, Samuelson has described the way the multiplier and accelerator interact with each other for generating income and increasing consumption and demand of investment. He also describes how these two factors are responsible for creating economic fluctuations.

Samuelson used two concepts, namely, autonomous and derived investment, to explain his model. Autonomous investment refers to the investment due to exogenous factors, such as new product, production technique, and market. On the other hand, derived investment refers to the increase in the investment of capital goods produced due to increase in the demand of consumer goods. When autonomous investment occurs in an economy, the income level also increases. This brought the role of multiplier into account. The income level helps in determining the marginal propensity to consume. If the income level increases, then the demand for consumer goods also increases.

The supply of consumer goods should satisfy the demand for consumer goods. This is possible when the production technique is capable to produce a large quantity of products and services. This encourages organizations to invest more to develop advanced production techniques and increase production for meeting consumer demand. Therefore, the consumption affects the demand of investment. This is referred as derived investment. This marks the starting of the acceleration process, which results in further increase in income level.

An increase in the income level would increase the demand of consumer goods. In this manner, the multiplier and accelerator interact with each other and make the income grow at a much higher rate than expected. Autonomous investment leads to multiplier effect that result in derived investment. This is called acceleration of investment. Derived investment would make the accelerator to come into action. This is termed as multiplier-acceleration interaction.

Samuelson made certain assumptions for the explanation of business cycles. Some of the assumptions are that the production capacity is limited and consumption takes place after a gap of one year. Another assumption made by him is that there would be a gap of one year between the increase in consumption and increase in the demand of investment. In addition, he assumed that there would be no government activity and foreign trade in the economy. According to the assumption given by Samuelson that there would be no government activity and foreign trade, the equilibrium would be achieved when

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Where, Yt = National income

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According to the assumption that consumption takes place after a gap of one year, the consumption function would be represented as follows:

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Investment and consumption has a time lag of one year; therefore, the investment function can be expressed a follows:

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Where, b = capital/output ratio (helps in determination of acceleration).By putting the value of Ct and It in the first equation of national income, we get

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With the help of preceding equation, the income level for past and future can be determined if the values of a, b and income of two preceding years are given. It can be depicted from the preceding equation that the changes in income level can be affected by the values of α and b. Samuelson identified five types of cyclical fluctuations: cycle-less path, damped fluctuations, fluctuation of constant amplitude, explosive cycles and cycle-less explosive path.

These theories though differ in their approaches in explaining business cycle, offer good explanations of the ECOWAS economies, and therefore form the basis of this study. Some of them highlight expansion and contraction in money supply, rise or fall in output, changes in investment, exchange rate instability, imbalance in export-import activities among others as the main causes of prosperity or otherwise of any economy.

2.2.3 Other Related Theoretical Issues

Besides the above basic theories reviewed above, there are other related theoretical issues bordering on business cycles which are also relevant in this current study. Briefly, we look at them.

1. The Classical Theory — (Self-Correcting Economy)

The classical theory of self-correcting economy posits that if every demand shift were followed by a simultaneous supply shift by the same amount in the same direction, then real income would never deviate from natural real GDP (YN) and there would be no business cycles. For instance, following a change in aggregate demand, if nominal wages change in proportion, then the aggregate supply curve shifts vertically by the same amount as the demand shift, with no change in real variables.

Self-correcting forces: the role of flexible prices in stabilising real GDP under some conditions. The classical economists assumed that the economy would not operate with real GDP (Y) away from the level of natural real GDP (YN) for any length of time: if Y < YN, then firms would be producing at below capacity, and would tend to cut nominal wages and prices, which would continue until YN was again reached. If Y > YN, then above capacity production could support hikes in nominal wages and prices, until real output fell back to YN. The consequence was no business cycle in real GDP, although there was a cycle in the price level from the original price (P0) down to a new price (P1) and up to the original price (P0) again.

2. Imperfect Information

The Friedman model serves several purposes:

- It offers the first alternative to the Keynesian assumptions of nominal wage rigidity and nonmarket- clearing to explain the existence of business cycles, and
- It contains some of the essential elements — market clearing and imperfect information — incorporated into the new classical theory.

The innovative feature of Friedman’s model is the specification of the labour supply curve to be dependent on the expected real wage (W/Pe) rather than the actual real wage (W/P). This implies that the presence of imperfect price information on the part of workers will allow the economy to deviate from the long-run natural level of output (YN) and generate business cycles.

Because the level of output is always equal to the natural real GDP (YN) when expectations are accurate, the long-run aggregate supply curve is vertical. The model, which obeys the natural rate hypothesis (shifts in aggregate demand have no long-run effect on real GDP) is sometimes called a “natural rate” model.

The short- and long-run results of the Friedman model are exactly the same as that of the aggregate demand and supply model of Gordon with the important difference that by expressing the labour supply curve as a function of the expected real wage, the Friedman model assumes continuous market clearing in the labour market without any need for workers to be off their labour supply curve in the short run. But because the principal criticism against the Friedman model is that because it is very hard to justify that workers can be “fooled” for any great length of time, it doesn’t provide a satisfactory theory of business cycles. As well as its importance to the development of modern business cycle theories, the Friedman model helps understanding of the new classical model, and of the major issues separating it and the new Keynesian model.

3. The New Classical Model

This model adds one important element to Friedman’s market-clearing and imperfect information: the assumption of rational expectations (which need not be correct, but make the best use of available information, avoiding errors that could have been foreseen by knowledge of history). People make their best forecasts of the future based on all data currently available rather than having to learn and catch up to the current situation.

Rational expectations (RE) can be distinguished from adaptive expectations (in which expectations for the next period’s values are based on an average of actual values during the previous periods) such as Friedman’s model uses. In RE models, individuals are forward-looking and adjust their expectations to their best forecasts of the future. With RE, errors in expectations occur only randomly and independently.

RE are incorporated into the Lucas-Friedman supply curve, which is given as linear. The reasoning underlying the Lucas supply curve is that whenever the expected price level equals the actual (Pe = P), the supply curve will be a vertical line at YN, and that output (Y) will only be responsive to changes in prices if the actual price level deviates from the expected level.

The slope of the supply curve can be understood by a distinction between local and aggregate supply shocks: individual producers will only be willing to supply more if the price of their product rises relative to the general price level (P). Each individual producer is assumed to know the price of its own product, but, because of information barriers, they cannot directly observe the price of other products (Lucas: “island”), thus, for any given price change, they must infer whether this is a local or an aggregate price shock. To the extent that their guess is incorrect, the economy will be able to deviate from the natural level of GDP and generate business cycles.

2.3 Empirical Literature Review

Debate over trends in the terms of trade between primary commodities and manufactures, their causes and their impact has dominated the literature for than a century. Classical economists claimed that the terms of trade of primary commodities should improve over times, since land and natural resources are in inelastic supply. Following the Great Depression, a new view emerged. What came to be known as the Prebisch-Singer thesis was instead that the terms of trade for primary products had deteriorated up to the 1950 (Hadass & Williamson, 2001). Since Prebisch-Singer hypothesis, there have been increasing amounts of empirical studies that investigated the trends in terms of trade, causes and effects. The findings are mixed and contentious debate in the literature continues.

The bulk of reviewed literature concentrated on the developed and emerging economies. Few literature such as Misztal, (2012); Dai and Chia, (2008); Andrews and Rees, (2009) and Broda, (2004) have focused in developing economies. Using various measurements, these studies have indicated that there was a significant relationship between terms of trade shock and macroeconomic performance. However each macroeconomic variable has its own response to the shock. We begin the empirical literature review from 1990s up.

Gregorio and Wolf (1994) examined the effects of terms of trade movements and productivity differentials across sectors on the behavior of the real exchange rate for 14 OECD countries from 1970 - 1985, with total factor productivity, price of export, price of import, terms of trade, government expenditure and GDP per capita as the variables of the model. Using seemingly unrelated regression (SURE), the findings indicate that there is fast productivity growth in the tradable sector relative to the non tradable sector. The findings also suggest that an improvement in terms of trade induce a real exchange rate appreciation. The evidence broadly supports the predictions of the model, namely that faster productivity growth in the tradable relative to the non tradable sector and an improvement in the terms of trade induce a real appreciation.

In a similar study, Mendoza (1995) examined the relationship between terms of trade and business cycle from the perspective of an intertemporal general equilibrium framework for some selected countries of the world. The sample spanned from 1955 to 1990 for G-7 countries and from 1960 - 1990 for DCs. The variables of the study include Terms of trade, GDP, real exchange rate, trade balance, private consumption and fixed investment. Utilizing regression techniques such as correlation and granger causality, the study reveals that terms of trade shocks account for nearly ½ of actual GDP variability. The study also explains weak correlation between net export and terms of trade (the Harberger, Laursen and Metzler effect) and produces large and weakly-correlated deviations from purchasing power parity and real interest rate parity. Terms of trade shocks causes real appreciations and positive interest differential, although productivity shocks have positive effect.

In another study, Gruen and Dwyer (1995) using quarterly seasonally adjusted data from 1972 through 1994 investigated the relationship between terms of trade shock and inflation in Australia. Using terms of trade, inflation and GDP as the variables and adopting regression analysis, the study indicates that terms of trade is crucial to the inflation outcome and there was an existence of threshold exchange rate response. The study suggests that a rise in the terms of trade is inflationary and if associated with rise in real exchange rate is less, about one third to a half of the rise term of trade and if real exchange rate is larger than this the consequent fall in the domestic price of importable is large enough that the terms of trade rise reduces inflation at least in the short run.

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