The Terms of Trade

Question 1

What are the terms of trade?

Answer 1

an index which measures the relative movements in the prices of exports and imports

• influences the balance of payments, exchange rate and national income
• important because it provides a measure of the quantity of imports a country can obtain in exchange for a given volume of exports

Question 2

How are the Terms of Trade calculated?

Answer 2

T.o.T = (export price index)/(import price index) x 100

Question 3

Describe causes of the movements in the terms of trade

Answer 3

Rise in terms of trade
- export prices relative to import prices rise, to purchase a given quantity of imports will require a smaller quantity of exports, would be synonymous with an increase in a country’s standard of living since more g & s could be imported for a given quantity of exports

Fall in terms of trade
- export $ fall relative to import $, consumers and producers have to increase spending to purchase the same amount of imports, exporters income will fall, can result in the level of national income and balance of g & s decreasing

Question 4

What are features of Australia’s terms of trade?

Answer 4

• our main export are primary commodities, main imports are manufactured goods, the $ of commodities is subject to large price fluctuations due to inelastic demand and supply
• our ToT are affected by changes in the global economy, Aus is said to be a price taker with respect to $ of traded goods, Aus’s exports and import prices are largely set in the world market

Question 5

What are trends in the terms of trade?

Answer 5

1991-2000: hovered around 50
2001-2011: double to 107, driven by economic growth in Asian countries
2008-09: decline due to GFC
2010-12: quick recovery and surge

Question 6

What prompted the mining boom?

Answer 6

• fueled by substantial ride in t.o.t
• strong global demand for commodities, consumption of coal and iron ore increased by more than 50%
• increase in resource investment
• appreciation of exchange rate - $A appreciated 50%
• mining exports significantly increased share of total g & s exports
• China emerged as largest manufacturer, driving down prices of manufactured goods

Question 7

How do changes in the terms of trade affect the current account balance in the balance of payments?

Answer 7

• generally there is a direct relationship
• rise in t.o.t normally causes an increase in the trade balance (smaller deficit/larger surplus) and a increase in the current account balance, can also cause a decrease because an increase in t.o.t increases national income which increases consumption which increases spending on imports

Question 8

How do changes in the terms of trade affect investment?

Answer 8

• the rise in Aus’s t.o.t this decade has also resulted in a massive increase in investment into the mining and resource sector, the doubling of coal and iron ore $ in 2001-02 attracted vast sums of capital into new mining projects to help boost supply capacity
• mining sector capital investment has doubled from 2 - 4% of GDP
• an increase in investment will increase capital goods imports and reduce both the trade and current account balances (reduce the trade surplus, increase the CAD)

Question 9

How does changes to the terms of trade affect the exchange rate?

Answer 9

• a strong t.o.t leads to an appreciation of the exchange rate
• the $A is often referred to as the commodity currency due to our dependency on commodity exports
• a higher $A is beneficial to consumers as it reduces the price of imported goods n services, however this is detrimental to exporters and producers not in the mining sector as it reduces their competitiveness. Known as the Dutch Disease, the mining boom caused by the rise in commodity exports, created a two speed economy where the mining sector boomed and other sectors were adversely affected by high exchange rates and grew at a much slower speed

Question 10

How do changes in the terms of trade affect the rate of inflation?

Answer 10

• a rise in the t.o.t by increasing national income and spending will have an expansionary effect on the economy and may be inflationary if economy is close to full capacity, the RBA may raise interest rates to curb inflationary pressures
• a fall in the t.o.t will have a contractionary effect on the economy as consumption spending, net exports and investment are reduced
  ~ 2011-14 t.o.t fell by 25% marking the end of the mining boom and had a contraction in the economy leading to falling economic growth and rising unemployment