What does the terms of trade measure and why does it matter so much for Australia?
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
WACE Year 12 Economics Unit 3 on the terms of trade: the index of export prices relative to import prices, how to calculate it, the commodity-driven causes of its movements, and the effects of a boom or bust on Australian incomes, the dollar and the current account.
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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
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.
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.
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.