The Terms of Trade

Question 1

Define the terms of trade.

Answer 1

The terms of trade is an index which measures the relative movements in the prices of exports and imports.

Question 2

When did Australia experience its largest sustained boost to the terms of trade in its history.

Answer 2

Between 2001 and 2012, Australia experienced its largest sustained boost to the terms of trade in its history -> resulting in Australia’s mining boom (increase in commodity prices).

Question 3

What do movements in the terms of trade influence?

Answer 3

Movements in the terms of trade can have a significant influence on the balance of payments, the exchange rate and national incomes.

Question 4

How will an increase in the general level of import/export prices impact consumers and producers?

Answer 4

An increase in the general level of import prices will mean that consumers and producers will generally be worse off -in order to consume the same quantity of goods, they will have to increase their spending.

An increase in the general level of export prices will be beneficial because export income will increase, adding to a country’s national income.

Question 5

What is the importance of the terms of trade index?

Answer 5

The importance of the terms of trade index is that it provides a measure of the quantity of imports a country can exchange for a given volume of exports,

Question 6

What will happen to standard of living if the terms of trade rise?

Answer 6

If the terms of trade rise, (that is export prices rise relative to import prices) then to purchase a given quantity of imports will require a smaller quantity of exports. In other words, a rise in the terms of trade would be synonymous with an increase in a country’s standard of living since more goods and services can be imported for a given amount of exports.

Question 7

Is the absolute value of the ToT relevant?

Answer 7

The absolute value of the ToT index is relatively unimportant- it is the movement of the index which is relevant.

Question 8

What type of movement is it if the terms of trade falls?

Answer 8

If the terms of trade falls, then this is referred to as an unfavorable movement.

Question 9

With reference to import and export prices, when will the ToT increase/decrease?

Answer 9

-> While both import and export prices rise, the terms of trade can fall if import prices rise at a faster rate than export prices.

• > If export prices increase more quickly than import prices, the terms of trade will increase.
• > The terms of trade will increase if both import and export prices decrease, but import prices decrease at a faster rate the export prices.

Question 10

What is the formula for terms of trade?

Answer 10

The terms of trade is a ration of export prices to import prices.

ToT= Export price index / Import price index x 100

export price index (yr 2) = yr 1 / yr 2 x 100

new= old / new x 100

Question 11

What do Australian exports and imports consists of mainly?

Answer 11

Australia’s exports consist mainly of primary commodities (especially resources), while imports are dominated by manufactured goods.

Question 12

Who is Australia’s dominant trading partner?

Answer 12

China.

Question 13

Why are the prices of commodities subject to large price fluctuations?
How do changes world demand for commodities impact Australia’s export price index?

Answer 13

The price of commodities can be subject to wide fluctuations due to inelastic demand and supply. Small shifts in demand or supply can cause large price swings. This means that wen the Chinese economy expands, the demand for resources (such as iron ore and coal) will increase which will boost world commodity prices and increase Australia’s export price index.

An increase in Australia’s export price index will (ceteris paribus) increase Australia’s terms of trade.
Conversely, it world economic growth contracts then the demand for resource commodities will fall, reducing commodity prices and reducing Australia’s export price index.

Question 14

What makes up the bulk of Australia’s imports?

How has the emergence of China as the world’s largest manufacturer effected Australia’s import price index?

Answer 14

The bulk of Australia’s imports are manufactured goods. The emergence of China as the world’s largest manufacturer has seen a fall in the price of manufactured goods, helping to reduce Australia’s import price index.

Question 15

What happened to the terms of trade between 2011 and 2016? Was this a favorable movement?
Why did this occur?

Answer 15

Between 2011 and 2016 the export price index fell in every year and declined by 26% over this period. This was due to the large fall incommodity prices.

The reason why the terms of trade FELL (unfavorable) over this period was due to a combination of a fall in the export price index and a side in the import price index.
HOWEVER, the export price index was most responsible for the change.

Question 16

Why is Australia said to be a price taker?

Answer 16

Australia is said to be a price taker with respect to the prices of traded goods. Australia has very little direct influence on its export and import price indices. Australia’s export and import prices are largely set in the world market. Australia’s main exports are resource which have no product differentiation, so we have to take the world price.

Question 17

Describe the trends in Australia's current account from 2004 to 2016.
Main years:
2004-2008
2009
2010-2012
2012-2016

Answer 17

The graph (see notes) shows that Australia’s terms of trade increased significantly from around 70 in 2004 to 106 in 2008 -> this was the first phase of the mining boom.

There was a dramatic decline in the ToT in 2009, this was due to the Global Financial Crisis.

The index quickly recovered and surged again through 2010-2012 -> the second stage of the mining boom, thanks to growth and industrialization in China.

Since 2012, the index plummeted from around 120 to 80 in 2016. Australia’s mining boom was now well and truly over as world commodity prices collapsed.

Question 18

What effect does economic activity have on a change in the terms of trade?

Answer 18

An increase in the terms of trade due to higher commodity prices will lead to an expansion in economic activity -> positive shock.
When commodity prices fall on the other hand, the terms of trade will decline -> negative shock, and economic activity will contract.

Question 19

What is gross domestic income?

Answer 19

GDP adjusted for terms of trade is known as gross domestic income (GDI). It is a better measure of a country’s real purchasing power than simply using the normal GDP figure.

Question 20

What effect does the trade account have on changes in the terms of trade?

Answer 20

There is a close link between the terms of trade and the trade account (goods and services balance) in the balance of payments.

ToT= measures changes in the PRICE of exports and imports.
Trade account= measures changes in the VALUE of exports and imports.

A rise in the ToT would normally cause an increase in the trade balance (decreased deficit) and therefore an increase in the current account balance. E.g. in 2011

Question 21

ToT= measures changes in the _____ of exports and imports.

Trade account= measures changes in the _____ of exports and imports.

Answer 21

ToT= measures changes in the PRICE of exports and imports.

Trade account= measures changes in the VALUE of exports and imports.

Question 22

When can a rise in the terms of trade lead to a fall in the trade balance? (When it usually leads to an increase in the trade balance).

Answer 22

A rise in the terms of trade can also have the opposite effect- leading to a fall in the trade balance.
A rise in the terms of trade increases national income which will increase consumption. This means that spending on imports will increase which may offset the increase in export income.
There could also be an increase in investment which will increase capital imports which will therefore reduce the trade balance.

Question 23

What effect does the exchange rate have on changes in the terms of trade?

Answer 23

Movements in the terms of trade have a direct impact on the exchange rate. A strong terms of trade will lead to an appreciation of the exchange rate.
Australia is dependent on commodity exports- high export prices increase the demand for the Australian dollar- boosting its value.
(E.g. the Australian dollar increased from 0.80USD in 2005 to 1.10USD in 2011.)
A higher AUD is good for consumers because it reduces the price of imported goods and services.
However, a higher exchange rate is a disadvantage for domestic producers, and exporters NOT in the mining sector, because it reduces their competitiveness.

Question 24

What is one potential problem of a very high exchange rate?

Answer 24

One potential problem of a very high exchange rate is known as ‘Dutch Disease.’
The mining boom caused by a rise in commodity prices resulted in a ‘TWO SPEED ECONOMY’. The mining sector boomed and grew at a fast pace, but other domestic industry were adversely affected by the high exchange rate and grew at a much slower speed.