Impact of terms of trade shocks on the South African economy.

Abstract

This dissertation investigates the impact of terms of trade shocks on the South African economy using a Dynamic Stochastic General Equilibrium (DSGE) model estimated with Bayesian methods. South Africa’s heavy dependence on commodity exports which account for approximately 60 percent of GDP—renders the economy highly vulnerable to fluctuations in global commodity prices, with significant implications for macroeconomic stability, growth, and policy. While existing studies have employed various methodologies including ARDL models and calibrated DSGE frameworks to examine external shocks, gaps remain in understanding the precise transmission channels, persistence, and sectoral propagation of terms of trade shocks within a structurally realistic, micro-founded model of the South African economy. To address these gaps, this study adapts a small open economy DSGE model ((Gali and Monacelli, 2005)) and estimate it using Bayesian techniques with quarterly data spanning 1994Q1 to 2024Q3. Key variables include domestic output, inflation, the real exchange rate, terms of trade, and foreign output and inflation. The Bayesian approach allows for the integration of prior information with observed data, improving parameter identification and enabling a robust analysis of shock transmission. Results indicate that terms of trade shocks are highly persistent (ρq ≈ 0.90) and constitute a major driver of South Africa’s business cycle fluctuations. Impulse response analysis reveals that a positive terms of trade shock boosts domestic output and appreciates the real exchange rate, with inflation responding gradually due to exchange rate pass-through effects. Variance decomposition shows that terms of trade shocks explain a substantial share of fluctuations in output, inflation, and the exchange rate, particularly over mediumto long-term horizons. Historical decomposition further confirms the dominant role of external commodity price shocks during key episodes such as the 2008–09 financial crisis and the post-2015 commodity downturn. The study concludes that South Africa’s commodity-dependent economic structure amplifies its exposure to global price volatility, with lasting effects on key macroeconomic variables. Policy recommendations include economic diversification, strengthened fiscal buffers, and enhanced monetary-fiscal coordination to mitigate external vulnerability. This research contributes to the academic literature by providing a structurally detailed, empirically grounded analysis of terms of trade shocks in South Africa and offers evidencebased insights for policymakers in small open commodity-exporting economies.