Terms of Trade Fluctuations and Sudden Stops in a Small Open Economy

We examine how terms‐of‐trade fluctuations can shape the vulnerability of emerging economies to self‐fulfilling financial crises and sudden stops. Building on a small open economy endowment model with importables, exportables, and nontradables, we allow the borrowing constraint to depend explicitly on the relative price of exports. This channel links terms‐of‐trade movements to the economy's collateral capacity. We find that while terms‐of‐trade shocks may play a limited role in routine business‐cycle dynamics, their importance intensifies under stressed conditions. Favorable terms‐of‐trade can deter the emergence of multiple equilibria and prevent expectation‐driven crises. Our findings contribute to understanding the high relevance associated with the terms‐of‐trade in emerging economies, even in the presence of the limited evidence of their importance as a fundamental driver during normal times.