Explain the terms of trade, how they are measured, the factors that cause them to change, and analyse the effects of a change in the terms of trade on the Australian economy

What this dot point is asking

QCAA wants you to define the terms of trade, explain how the index is constructed, identify what causes it to rise or fall, and analyse the flow-on effects of a change in the terms of trade for national income, the exchange rate, the current account and the federal Budget. Because Australia is a commodity-exporting economy, the terms of trade is a recurring focus in Unit 3. Expect a 5 to 8 mark response in IA1 or the EA.

The answer

What the terms of trade are

The terms of trade (ToT) measure the ratio of the prices a country receives for its exports to the prices it pays for its imports. They tell you how many units of imports a country can buy with a given quantity of exports.

The ABS publishes the terms of trade in the National Accounts (cat. no. 5206.0). The index is set to 100 in a base year. Because it is a ratio of price indexes, it captures prices, not volumes.

Improvement versus deterioration

• An improvement (rise) in the terms of trade means export prices have risen relative to import prices. A given basket of exports now buys more imports. The country is better off per unit traded.
• A deterioration (fall) means export prices have fallen relative to import prices, so a given basket of exports buys fewer imports.

For Australia the terms of trade are dominated by commodity prices, because bulk commodities (iron ore, coal, LNG) make up a large share of exports, while imports are mostly manufactured goods and services with more stable prices.

What causes the terms of trade to change

Export price drivers:

• Global commodity demand. Strong demand from major trading partners (especially East Asian steel and energy demand) raises the prices of iron ore, coal and LNG and lifts the terms of trade.
• Global commodity supply. New mine capacity from Australia and competitors (for example Brazilian iron ore) tends to lower export prices.
• Global growth and the commodity cycle. Booms lift commodity prices; downturns depress them.

Import price drivers:

• World prices of manufactured goods and energy. Lower world prices for the goods Australia imports raise the terms of trade.
• The exchange rate affects measured import and export prices, although the terms of trade and the exchange rate also influence each other (see below).

Effects of a rise in the terms of trade

A sustained improvement in the terms of trade is, in effect, a positive income shock for Australia. Trace the chain:

1. Higher export incomes. Higher commodity prices raise mining export revenue and company profits.
2. Higher national income. Real gross domestic income and real net national disposable income rise by more than real GDP, because the country earns more for what it sells. This is why real net national disposable income per capita is often a better welfare measure than real GDP for Australia.
3. Currency appreciation. Higher export prices raise foreign demand for the AUD, tending to appreciate the dollar. The AUD is sometimes described as a commodity currency for this reason.
4. Current account improvement. A higher export price index lifts the value of exports and improves the balance on goods and services (subject to volumes).
5. Stronger Budget position. Higher company profits raise company tax receipts, improving the federal Budget. Treasury typically assumes commodity prices fall back to conservative long-run levels, so a sustained high terms of trade delivers revenue upgrades.

A deterioration runs the chain in reverse: lower export incomes, lower national income, a tendency for the AUD to depreciate, a weaker current account on the price side, and lower company tax receipts.

The terms of trade and the exchange rate

The two are linked but distinct. A rise in the terms of trade tends to cause the AUD to appreciate, because higher commodity prices raise demand for Australian dollars. The exchange rate then acts as a partial automatic stabiliser: an appreciating dollar dampens some of the domestic boom by making exports less competitive and imports cheaper. Do not treat the terms of trade and the exchange rate as the same thing; the terms of trade is a price ratio, while the exchange rate is the price of the currency.

Why it matters for Australia

Because Australia is heavily exposed to commodity prices, the terms of trade are one of the most important external influences on the economy. Swings in the terms of trade drive national income, the exchange rate, the current account and the Budget. The historic mining boom from the early 2000s lifted the terms of trade to multi-decade highs and was a major source of rising Australian living standards; subsequent moderation in commodity prices reversed part of that gain. For the latest terms of trade figures, refer to the most recent ABS National Accounts release.

Examples in context

Example 1. A commodity demand surge. Suppose strong steel demand from major trading partners pushes iron ore and coal prices sharply higher while the prices of Australia's imported manufactures are little changed. The export price index rises faster than the import price index, so the terms of trade improve. Mining revenue and company profits rise, lifting real national income and company tax receipts, while the AUD tends to appreciate. Treasury would likely upgrade Budget revenue forecasts, although it would assume prices eventually return to conservative long-run levels.

Example 2. Using the right income measure. When the terms of trade are high, real GDP may understate the gain to living standards, because GDP measures volume of output, not the better prices Australia is receiving. Real net national disposable income per capita rises by more than real GDP per capita in a terms-of-trade boom, which is why economists prefer it as a welfare measure for a commodity exporter. The opposite holds in a terms-of-trade downturn.

Try this

Q1. Define the terms of trade and write the formula for the terms of trade index. [2 marks]

• Cue. The ratio of export prices to import prices; index = (export price index / import price index) x 100.

Q2. Explain two factors that could cause Australia's terms of trade to improve. [4 marks]

• Cue. A rise in global demand for commodities (raising iron ore, coal and LNG export prices); a fall in the world prices of Australia's imported manufactured goods (lowering the import price index). Either raises export prices relative to import prices.

Q3. Analyse the effects of a sustained improvement in Australia's terms of trade on national income, the exchange rate and the federal Budget. [6 marks]

• Cue. Higher export prices raise mining export incomes and profits; real national income (real net national disposable income per capita) rises by more than real GDP; the AUD tends to appreciate as demand for the dollar rises; company tax receipts rise, improving the Budget; note that an appreciating dollar partly offsets the domestic boom and that Treasury assumes prices revert to conservative long-run levels.