Terms of trade Flashcards
What are the terms of trade?
An index which measures the relative movements in the prices of exports and imports
What does the terms of trade influence?
Balance of payments
The exchange rate
National income
Why is the terms of trade so important?
what does it provide a measure of
- It provides a measure of the quantity of imports a country can obtain in exchange for a given volume of exports
What does it mean when the terms of trade increases?
- To purchase a given quantity of imports it will require a smaller quantity of exports
- A rise in the terms of trade would be synonymous with an increase in a county’s standard of living since more goods and services can be imported from a given amount of exports
Equation for the ToT
terms of trade= (export price index)/(import price index) ×100
What is a favourable movement in the terms of trade?
- Occurs when export prices increase more than import prices
- Terms of trade increases
What is an unfavourable movement in the terms of trade?
- Import prices increase more than export prices
- Terms of trade decreases
How can export and import prices both fall, but the terms of trade still increase?
- Import prices fall by a greater proportion than export prices
Why are there large fluctuations in the prices of commodities?
- Due to the inelastic demand and supply
- Small shifts in demand and supply can cause large fluctuations
Australia’s terms of trade are affected by what changes in the global economy?
- Increases world economic growth
- Increases the demand for our commodities such as minerals and energy
- Increases their prices on the world market
Why does Australia have little influence on export and import prices?
- Prices are largely set in the world market
- Australia is a price taker when it comes to traded goods
Describe the ToT over the past two centuries
1991-2001 → Stable terms of trade (around 50)
2001-2011 → Index doubled due to the mining boom (went from 52 to around 107)
2008-2009 → There was a decline in the ToT due to the GFC
2010-2012 → The index recovered
Since 2012 → World commodity prices have been falling, decreasing the terms of trade
Effect of the resources boom on the ToT?
- Caused an increase in the ToT
- There was strong demand for our commodities
- This was associated with a massive increase in resource investment and a large appreciation of the exchange rate
What was the effect of emerging market economies on the ToT?
- China and India
- Resulted in an increase in demand for our commodities
- GDP growth per capita: 5.5% in India, 10% in China
- There was a huge demand for iron ore, coal and natural gas
What did the terms of trade have a prominent effect on?
- The trade and current account balance in the balance of payments
- The exchange rate
- National income
- Investment
- Inflation
What is the link between the terms of trade and the trade account in the balance of payments
- The terms of trade measures changes in the prices of exports and imports
- The trade account measures the changes in the value of exports and imports
- The trade account takes into account the prices of trades goods, as well as their quantities
What is the relationship between the terms of trade and the balance of goods and services?
(examples eg. mining boom)
- Direct relationship
- A rise in the terms of trade would cause an increase in the trade balance and an increase in the current account balance
EG. During the mining boom (2001-2012) - Australia’s export index increased (due to the increased demand for our commodities)
- There were higher prices and higher sales for resource exports
- The balance on goods and services increased
How can a rise in the terms of trade cause a decrease on the trade account?
- A rise in the terms of trade increases national income
- Increases consumption
- Spending on consumer imports will increase which may offset the increase in export income
Effects of changes in the terms of trade on investment
The increased terms of trade during the mining boom resulted in an increase in investment into the mining and resource sector
The doubling of coal and iron ore prices (2011-12) attracted vast sums of capital into new mining projects to help boost supply capacity
Effects of changes in the terms of trade on national income
A rise in the terms of trade will increase a country’s purchasing power, thereby increasing their real national income
↑ income = ↑ domestic economic activity and employment
Therefore, ↑ ToT leads to a boost in economic growth and living standards
What is the difference between real gross income and GDP?
GDP provides an accurate measure of the volume of goods and services produced in an economy
- although it does not provide an accurate measure of the real purchasing power of the income generated by domestic production
Real gross income → GDP adjusted for the terms of trade and is a better measure of a country’s real purchasing power
Effects of changes in the terms of trade on the exchange rates
- Strong terms of trade will lead to an appreciation of the exchange rate
- High export prices increases the demand for the Australian dollar, boosting its value
- Between 2001-11 the value of the $A increased from $US0.50 to $US1.10
- This reduced the price for imported goods and services
What is the dutch decrease?
- A high exchange rate is a disadvantage for domestic producers and exporters not in the mining sector
- It reduces the competitiveness of their industries
- Results in a ‘two speed’ economy
- The mining sector boomed at a fast pace
- Other domestic industries were adversely affected by the high exchange rate and grew at a much slower pace
How does a rise in the terms of trade effect the inflation rate?
- By increasing national income and spending, will have an expansionary effect on the economy and may be inflationary if the economy becomes close to full employment
- may cause the reserve bank to raise interest rates
How does a fall in the terms of trade effect the inflation rate?
- Cause a contraction in the economy
- Decreases net exports, investment and consumption spending
- 2011-14 ToT fell by 25%
- This marked the end of the mining boom
- Fall in economic growth and rising unemployment
