Terms of trade: WACE Year 12 Economics Unit 3
“Define and calculate the terms of trade, explain the causes of movements in Australia's terms of trade, and analyse the effects of a rising or falling terms of trade on national income and the balance of payments”
The terms of trade is an index of export prices divided by import prices, multiplied by 100. A rise means each unit of exports buys more imports, lifting national income; a fall does the reverse. Australia's terms of trade are dominated by commodity prices, so they swing sharply with the iron ore, coal and gas cycle.
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What this dot point is asking
SCSA wants you to define and calculate the terms of trade, explain why Australia's move so much, and trace the effects of a change on real income, the exchange rate and the current account. Expect a calculation from an index table plus a short or extended response linking the terms of trade to the wider economy.
Defining and calculating the terms of trade
The terms of trade (TOT) is the ratio of the price index of exports to the price index of imports, expressed as an index. It measures the quantity of imports a country can buy with a given quantity of exports.
Terms of trade = (Export price index / Import price index) x 100. A reading above the base year (100) means export prices have risen faster than import prices.
If Australia's export price index is 130 and its import price index is 104, the terms of trade equal 130 divided by 104, times 100, which is 125. Each unit of exports now buys 25 percent more imports than in the base year.
Causes of movements in Australia's terms of trade
Because around two thirds of Australian export earnings come from commodities, the terms of trade are driven mainly by world commodity prices.
- Global demand for resources. China's industrialisation drove iron ore and coal prices to record highs in the 2000s and again after 2020, lifting export prices and the terms of trade.
- Global supply. New mine capacity, OPEC decisions on oil, and supply disruptions move commodity prices.
- Import prices. Cheaper manufactured imports from Asia held Australia's import price index down for decades, supporting a high terms of trade.
- Exchange rate interaction. Movements feed both ways: a commodity price surge lifts the terms of trade and tends to appreciate the dollar.
Australia's terms of trade reached record highs during the mining boom around 2011 and again in 2021 to 2022 as iron ore and energy prices surged. The Reserve Bank has described the post-2003 terms of trade rise as one of the largest and most sustained in Australian history, adding substantially to national income before partially unwinding.
Effects of a change in the terms of trade
A rising terms of trade
- National income rises. Each export unit buys more imports, so real purchasing power and gross national income increase even if export volumes are unchanged.
- The dollar appreciates. Higher commodity export revenue raises demand for the AUD.
- The current account can improve through higher export values, though a stronger dollar may erode competitiveness over time.
- Company profits and tax revenue rise, which helped Australia return to budget surplus in 2022 to 2024.
A falling terms of trade
- National income falls, squeezing profits, wages and government revenue.
- The dollar depreciates, cushioning exporters (the shock-absorber effect).
- Mining investment slows, as occurred after the 2011 peak when the economy transitioned from the investment phase to the production phase of the boom.
Suppose iron ore prices double while import prices are steady. The export price index jumps, lifting the terms of trade. Mining firms earn higher revenue per tonne, paying more company tax and dividends. Demand for AUD rises, appreciating the dollar, which lowers import prices and helps contain inflation. National income rises even though the physical volume of ore exported has not changed. This is why economists watch the terms of trade as a key driver of Australian living standards.
Distinguishing the terms of trade from the trade balance
A common point of confusion: the terms of trade is about prices, not values or volumes. The terms of trade can rise while the trade balance worsens (if volumes fall faster than prices rise), or fall while the trade balance improves. Keep the price index meaning separate from the dollar value of net exports.
A falling terms of trade lowers national income, but the floating dollar usually depreciates at the same time, restoring competitiveness for exporters and acting as an automatic stabiliser. Evaluate both effects rather than assuming a falling terms of trade is uniformly harmful to the economy.
Exam-style questions
Questions in the style of SCSA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
WACE 2022-style8 marksDefine the terms of trade and explain the main causes of movements in Australia's terms of trade.Show worked answer →
An 8 mark response needs the definition, the formula, and the causes.
Definition. The terms of trade is an index of export prices relative to import prices, . A rise means a given volume of exports buys more imports.
Causes for Australia. Movements are dominated by world commodity prices because exports are concentrated in iron ore, coal and LNG. Global demand, especially from China, drives those prices; the mining boom lifted the terms of trade to a record around 2011, and high commodity prices lifted them again in 2021 to 2022. Import prices (mostly manufactures and oil) move less sharply, so the ratio is driven mainly by the volatile export side. The exchange rate and global supply conditions also matter.
Markers reward the price-ratio definition, the commodity dominance of the export index, and named episodes.
WACE 2023-style6 marksAnalyse the effects of a sustained fall in Australia's terms of trade on national income and the current account.Show worked answer →
A 6 mark response needs the income and external effects of a fall.
National income. A falling terms of trade means export prices are falling relative to import prices, so each unit of exports buys fewer imports. Export revenue, mining profits, wages in resource regions and government tax revenue all fall, reducing real national income even if export volumes are steady.
Current account. Lower export prices worsen the balance on goods and services, pushing the current account toward deficit. The Australian dollar usually depreciates alongside falling commodity prices, which cushions exporters and partly offsets the deterioration over time.
Markers reward the price (not volume) channel for income, the worsening trade balance, and the cushioning depreciation.