Statement 4: Australia's Terms of Trade - Stronger and Less Volatile
Contents
Part I: Introduction 4-3
Part II: Terms of trade movements - causes and effects 4-5
Part III: History of the terms of trade 4-9
Part IV: Drivers of the terms of trade 4-12
Effect of major world economic events on the terms of trade 4-12
Greater diversification in Australia's exports 4-15
Diversification of imports, with a rising share of Information and Communications Technology 4-16
An illustration of the impact of the changing export and import baskets 4-17
Diversification of exports and imports across different markets 4-19
Trends in export and import prices 4-20
Part V: Conclusions and policy implications 4-29
In recent years, Australia has enjoyed both stronger and less volatile terms of trade, which has raised real incomes, contributed to macroeconomic stability and reduced inflationary pressures. This favourable conjunction has been supported by a more dynamic and efficient private sector in an environment of increased internationalisation, sound macroeconomic policy and sustained microeconomic reform.
Part I: Introduction
The terms of trade - the ratio of export prices to import prices - is an important economic measure. It reflects the capacity of any given amount of exports to pay for a quantity of imports. A rise in the terms of trade enables Australia to buy more imports for a given quantity of exports and thereby increases domestic real income. However, terms of trade volatility tends to induce volatility in consumer spending, investment, economic growth and inflation, and has traditionally made macroeconomic management more difficult.
Through much of its history, Australia has faced declining and highly volatile terms of trade. However, since the trough reached in 1986, the terms of trade has exhibited markedly less volatility, and perhaps a slight upward trend.
Historically, Australia's terms of trade was positively correlated with world economic growth: when world economic growth was strong, the terms of trade rose; when world growth was weak, the terms of trade fell. In contrast, since 2000 Australia's terms of trade has increased despite the slowing of the world economy.
Further, in the past terms of trade increases usually added to inflationary pressures. While still too early to be definitive, recent evidence suggests that this relationship may have changed. The rising terms of trade has more recently reflected import price declines and therefore has tended to put downward pressure on inflation, with consequent benefits for macroeconomic management.
There are a number of factors that have led to a more stable and relatively strong terms of trade. One factor is the diversification of Australia's exports, across both products and markets. A second factor, contributing to Australia's strengthening terms of trade, is significant falls in the prices of Australia's imports, especially for information and communications technology (ICT) goods.
A third factor, contributing to terms of trade stability, is a more stable global economy relative to earlier times. This probably reflects, at least in part, policy improvements adopted by many industrial countries, and could well be an outcome of globalisation, which has promoted international competition, productivity and policy discipline.
While future movements in the terms of trade are uncertain, there are good prospects that terms of trade volatility will remain subdued with the possibility of an upward trend, as long as macroeconomic policy remains sound and microeconomic reform advances.1
The remainder of this Statement examines aspects of the terms of trade in more detail. Part II examines the major causes and effects of terms of trade movements. Part III looks at the history of Australia's terms of trade. Part IV investigates the key drivers of the terms of trade, including the diversification of exports and imports across products and markets, and the principal price trends. Finally, Part V concludes with some policy messages.
1 Sound domestic macroeconomic and microeconomic policies are crucial for reduced terms of trade volatility and increased relative strength. Sound international macroeconomic and microeconomic policies may provide additional stability benefits for Australia's terms of trade, but it is unclear what impact this has on the level of the terms of trade.
