The terms of trade is an index which measures the relative movements in the prices of exports and imports
- The terms of trade index is measured as a ratio of export prices to import prices
- Terms of Trade = (Export Price Index / Import Price Index) x 100
- These are change in prices of exports/imports
Changes in price of exports and imports affect the value of exports and imports:
- Therefore, movements in the terms of trade can have a significant influence on the trade and current account balance, the exchange rate and national income (GDP)
The importance of the terms of trade index is that it provides a measure of the quantity of imports a country can obtain in exchange for a given volume of exports.
- If the terms of trade rises, then to purchase a given quantity of imports will require a smaller quantity of exports.
- Rises in terms of trade is referred to as a favourable movement - since there is an increase in standard of living
An Example: Export prices
- BHP is receiving 60 dollars per tonne of iron ore and is exporting 1 billion tonnes -This means that the value of their exports equals 60 dollars billion.
- If the world price of iron ore rises to 80 dollars per tonne, the value of their 1 billion exports is now 80 billion dollars
- This is good for Australia: its export price index has risen – this will increase the trade balance and result in an increase in Australia’s national income.
An Example: Import prices
- One of Australia’s main imports is petroleum refined from oil.
- If oil prices increase from 50 dollars per barrel to 60 dollars dollars per barrel, the value of oil imports will increase by 20 percent.
- A rise in oil prices, ceteris paribus, will increase the import price index - this means that Australian households and firms will face a higher petrol bill.
An index number is a statistical device used to express price changes as a percentage of prices in a base year.
- You set a point of reference and set it at 100, any deviations from that year influence the index from 100
Remember: Australia’s exports consist mainly of primary commodities (especially resources), while imports are denominated by manufactured goods.
- If such a large proportion of exports are commodity prices, an increase in commodity price index will increase Autralia’s export price index and the terms of trade.
The price of commodities can be subject to WIDE FLUCTUATIONS due to their inelastic demand and supply - small shifts in demand and/or supply will cause large price swings.
- Increases in demand for commodity prices due to other foreign economies expanding, will increase the Australia’s export price index.
- Australia exporters will allow them to sell their output for higher prices and increase their export revenue.
The bulk of Australia’s imports are manufactured and intermediate goods.
- The supply of manufactured goods is relatively more elastic so changes in demand do not cause large supply swings
- Manufactured goods can be stored and have stock changing supply easily
Export price index has a much higher impact on terms of trade - a key driver.
Effects of a changes in terms of trade
Changes in the terms of trade have important effects on:
- The business cycle
- Economics Growth
- Output and employment
- The trade and current account balance in the balance of payments
- Improvements of trade balance have a close link in increases in terms of trades
- The exchange rate
- Increase in demand for your currency, your currency appreciates
- If everyone wants the goods your country produces, your currency will be very strong. (A large part that affects exchange rate is the demand for goods)
- National income
- Basically same as business cycle
- Government tax revenue
- Increase in production means increase in profit and employment, so increase in company and income taxes, increase in tax revenue means increase in terms of trade
- Standard of living
- As terms of trade improve, a higher level income increases, and material standard of living standards increase
- Investment (likely in resources sector)
- Increases in prices, more production, increases in profit, other countries will want to invest in it so increase in investment.
Trade balance takes into account not only prices of traded goods but their quantities as well.
Generally the terms of trade and the balance of goods and services will show a positive relationship.
- This is because a rise in export prices will increase the value of export revenue. (For commodities in Australia)
It is important to remember that that the terms of trade is one of many factors that will affect the trade of balance.
Effects of a change in the terms of trade in a table
| Favourable | Unfavourable | |
|---|---|---|
| Cause | The XPI rises relative to the MPI e.g. an increase in iron ore prices | The MPI rises relative to the XPI e.g. an increase in oil prices |
| Meaning | More imports can be purchased from a given volume of exports | Less imports can be purchased with a given volume of exports |
| Effects | 1. Increase in trade balance | 1. Decrease in trade balance |
| 2. Increase in national income | 2. Decrease in national income | |
| 3. Aggregate demand increases | 3. Aggregate demand decreases | |
| 4. Rise in living standards | 4. Fall in living standards | |
| 5. Investment & employment increases in the resources sector | 5. Investment & Employment decreases | |
| 6. AUD appreciates | 6. AUD Decreciates | |
| 7. CPI (Inflation) Rises | 7. CPI (Inflation) Falls |
While a higher Australian dollar is good for consumers it is a disadvantage for domestic producers and exporters not in the mining escort because it reduces their competitiveness.
- Foreign imports are cheaper than domestic produced goods
- Benefits domestic producers who use imported goods
- Exporters depend on prices of products in foreign markets
There are fewer substitutes to commodities so that is why commodities are non-elastic.
Dutch disease refers to the growth of one sector affecting the growth of other sectors.
- One potential problem of a very high exchange rate is known as ‘Dutch disease’. - the mining boom in Australia caused by the rise in commodity prices resulted in a ‘two speed’ economy.
- The mining sector grew at a fast pace but other domestic industries, adversely affected by the high exchange rate, grew at a much slower speed.
- If your product is price elastic, total revenue falls because it is more expensive in foreign markets to buy your exports
Terms of trade - Mostly microeconomics so demand and supply affects import and export prices. The factors that affect terms of trade are out of our reach to influence (world price is a flat line), so emphasis is on the terms of trade effects.
India’s and China’s economies were growing quicky in 2013-ish so they could affect the world price. Normally not one country can influence the world price.