**Table 8. Variance decomposition of GDP volatility (with terms of trade): By population size**

|||**Small c**|**ountries: by**|**populati**|**on**||**Large co**|**untries: by**|**populati**|**on**|**mean diff**|**median diff**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
||**N**|**mean**|**median**|**p25**|**p75**|**N**|**mean**|**median**|**p25**|**p75**|||
|**(log) tot**|5|0.150|0.027|0.024|0.039|16|0.077|0.036|0.014|0.142|-0.074|0.008|
|**rrate_us**|5|0.044|0.013|0.008|0.060|16|0.135|0.108|0.065|0.177|0.091**|0.095|
|**(log) gdp_us**|5|0.055|0.052|0.009|0.087|16|0.156|0.088|0.050|0.217|0.101|0.036|
|**(log) govexp**|5|0.108|0.064|0.061|0.103|16|0.086|0.084|0.025|0.104|-0.022|0.020|
|**tby**|5|0.023|0.008|0.006|0.010|16|0.056|0.048|0.018|0.091|0.033*|0.040|
|**rrate**|5|0.051|0.033|0.002|0.060|16|0.035|0.030|0.011|0.043|-0.017|-0.003|
|**(log) gdp**|5|0.540|0.562|0.516|0.704|16|0.397|0.427|0.328|0.527|-0.143|-0.135*|
|**(log) reer**|5|0.028|0.004|0.004|0.021|16|0.058|0.025|0.008|0.097|0.030|0.021|

We find the results to be quite similar to those obtained for the benchmark specification without terms of trade. For instance, the role played by external factors is more pronounced in large economies, where they contribute 37% to GDP volatility relative to small economies where they contribute just 25%, on average. While world interest rates and foreign demand are less important in small economies, terms of trade tend to play a larger role in these economies. For instance, the contribution of the terms of trade shocks to GDP volatility is equal to 15% in small economies – twice the corresponding contribution in large countries. Greater contribution of terms of trade shocks in small economies is not surprising given higher concentration of their exports coupled with greater trade openness.

Among the domestic factors, we find that shocks to GDP are more important in smaller economies (54% in small economies vs 40% in large, on average), very much in line with our benchmark findings, and this difference is statistically significant.

We also re-estimate panel VARs for this new specification with terms of trade and find the impulse responses to be similar to those reported above. Overall, our results are robust to the inclusion of terms of trade into the estimation.<sup>5</sup>

# **5. Discussion and policy recommendations**

Our main results can be summarized as follows. First, we find that GDP volatility in all countries in our sample is driven predominantly by domestic shocks. Second, we find significant differences in the sources of shocks in small and large economies. Specifically, we show that external factors, such as world interest rate and world demand conditions play a more important role in larger economies. GDP volatility in small economies, in contrast, is attributed predominantly to shocks to domestic output and terms of trade. Third, we find that these dichotomies in the behavior of small and large countries are driven primarily by developing countries. In addition, we find that within developing countries group, large economies are more exposed to real exchange rate shocks relative to small economies.

> 5 At the same time, the results should be taken with some caution given the small number of countries with terms of trade data among the groups of small countries and developing countries.

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