EFFECTS OF TERMS OF TRADE SHOCKS ON ECONOMIC GROWTH IN MALAWI UNDER DIFFERENT STABILITY BASED EXCHANGE RATE REGIMES

Abstract

This study examines the relationship between terms of trade and economic growth in Malawi. The research is founded on the underlying assumption that terms of trade shocks have effects on economic growth. This study also considers the effects of these shocks in different stability based exchange rate regimes. The study employs a threshold vector autoregression analysis method using time series annual data from 1970 to 2014. Two variability exchange rate regimes are chosen by the model indicating that there is a single threshold value. Moreover, Innovation accounting is used to investigate relationships among the variables. The results indicate that there are nonlinear relationships among the endogenous variables and hence justifies the use of the threshold vector autoregression analysis. The analysis also shows that terms of trade shocks have significant effects on economic growth in some time periods after a shock. The study further reveals that the exchange rate regimes also matter in how these terms of trade shocks affect economic growth. The high variability exchange rate regime seems to insulate the economy from terms of trade shocks than the low variability regime. The results found from this volatility based exchange rate classification supports the Freidman’s hypothesis that flexible exchange rates are shock absorbers. Furthermore, the study concludes that more liberalized exchange rate systems which have high variability in the exchange rate are the best policy stance for Malawi. Therefore, the results suggest there is need to implement high variability exchange rate regimes in Malawi to insulate the economy from terms of trade shocks.