Statement 4: Australia's Terms of Trade - Stronger and Less Volatile
Part II: Terms of trade movements -
causes and effects
There are two key components of Australia's terms of trade: world prices of Australia's exports and imports, and the composition of the export and import baskets. While Australia has little ability to affect the world relative prices of its imports and exports, developments within Australia can influence the terms of trade to the extent that such developments affect the composition of the export and import baskets. For example, an increase in the world price of coal relative to ICT goods will increase the terms of trade because Australia is a net exporter of coal and a net importer of ICT goods. Similarly, an increase in the relative weighting of a more expensive export (with relative prices held constant) will also increase the terms of trade.
Increases (falls) in the level of the terms of trade raise (reduce) domestic real income by increasing (reducing) the purchasing power of Australia's exports (Box 1). This, in turn, can have flow on effects through the economy to the extent that it results in changes in household spending, business profits, business investment, production and employment.
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Box 1: Real gross domestic income and the terms of trade GDP measures the volumes of goods and services produced in Australia, not the volumes consumed in Australia. If the terms of trade change significantly over any period, then the measure of GDP will not accurately reflect the changes in real purchasing power of the income generated by domestic production. One measure that attempts to capture the terms of trade effects, or changes in real purchasing power of the income generated by domestic production, is real gross domestic income (real GDI). Chart A illustrates that there has been a broad relationship between the terms of trade and the growth rates of real GDI. Chart A: The terms of trade and real gross domestic income
Source: ABS Cat. No. 5206.0. |
Before the floating of the Australian dollar, sharp increases in the terms of trade often provoked significant outbreaks of inflation. For example, when wool prices soared during the Korean War, inflation increased dramatically, reaching 22.4 per cent in 1951-52. Notwithstanding difficulties with the policy response, inflation subsequently returned to lower levels, falling to 0.9 per cent in 1954-55.2
More recently, however, evidence is mounting that - with a floating exchange rate - terms of trade increases are having less impact on domestic inflationary pressures, and may well reduce and stabilise those pressures under some circumstances. There are likely to be several factors at work. First, while increased real income flowing from a stronger terms of trade tends to result in additional domestic expenditure and hence inflationary pressures, this is likely to be at least partly offset by lower import prices in response to a rising exchange rate.3 Second, a floating exchange rate provides a level of insulation against abrupt changes in the terms of trade and therefore tends to reduce inflation volatility. Third, if terms of trade increases are driven principally by falls in import prices on world markets (as in Australia over recent years), rather than rises in export prices, there will tend to be a reduction in inflationary pressures flowing through from lower input costs to production and lower prices to consumers. The historical relationship between the terms of trade and the nominal and real exchange rates is discussed in more detail in Box 2.4
While movements in the level of the terms of trade affect real income, significant terms of trade volatility can be destabilising and can affect economic efficiency. For example, where consumers and producers misdiagnose the extent and duration of a change in the terms of trade, efficient resource movements are likely to be impeded as price signals are misread. This tends to inhibit both productivity growth and economic growth because the free flow of resources to their most efficient use is likely to be impeded.
Firms may also experience significant costs associated with high terms of trade volatility. Borrowing costs can increase as lenders charge higher premiums to account for risk, while the volatility may reduce the incentive for firms to invest.
High levels of volatility in the terms of trade can therefore seriously disrupt an economy, increasing the volatility of its growth rate and making macroeconomic policy relatively more difficult to implement. Monetary authorities are more at risk of over- or under-estimating the stimulus/contraction required to maintain low and stable inflation. This tends to increase the volatility of inflation, thus adding to general economic instability. The operation and control of fiscal policy can be similarly more difficult under such circumstances.
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Box 2: Nominal and real exchange rates and the terms of trade Chart A compares the terms of trade to the nominal and real exchange rates since the mid-1980s. There has been a broad positive correlation between the terms of trade and the exchange rate over most of this period. More recently, while the terms of trade has increased since the worst of the Asian financial crisis in mid-1998, the nominal and real exchange rates have fallen. One factor that has assisted to boost the terms of trade following the Asian financial crisis was that Australia's import prices tend to be affected by regional influences, while its export prices tend to be set on the world market. Therefore, in the short-term, the world prices of Australia's imports fell more rapidly than the prices of its exports. This would normally tend to boost Australia's exchange rates. However, there are at least two factors that may help explain the recently observed divergence in movements in the real exchange rate and the terms of trade. One factor is the uneven productivity growth in the tradeable and non-tradeable sectors. If productivity in the non-tradeable sector grows relatively more rapidly than the tradeable sector, the real exchange rate will tend to depreciate, other factors unchanged. Over the 1990s, there has been relatively rapid productivity growth in Australia's non-tradeable sector, particularly in industries such as wholesale trade, finance and insurance, utilities and construction, as a result of increased domestic competition. A second factor for recent falls in the nominal and real exchange rates may be the strength of the US dollar, driven in part by capital flows, which may lead to the Australian nominal and real exchange rates being below their fundamental levels in the short-term. Chart A: Exchange rates and the terms of trade
Source: ABS Cat. No. 5206.0 and 5302.0, Reserve Bank of Australia. |
2 In an environment of fixed exchange rates, in order to mute inflationary pressures following a rise in the terms of trade, the exchange rate needed to be revalued. In practice this was difficult, as it directly affected exporters and those in import-competing industries. During the 1950s, this tension resulted in a slow response to movements in the terms of trade, thereby contributing to sharp volatility in inflation.
3 See Gruen, D. and J. Dwyer, Are terms of trade rises inflationary?, Research Discussion Paper 9508, Reserve Bank of Australia, 1995.
4 More detail may also be found in MacDonald, Ronald and Luca Ricci, `Purchasing Power Parity and New Trade Theory', International Monetary Fund Working Paper WP/02/32, 2002.
