Booklet 5 - Terms of Trade

What do you Discuss when Asked About - The Concept of the Terms of Trade & the Terms of Trade Index

Define Terms of Trade

Terms of Trade Formula

Two Reasons for a Favourable Movement in the Terms of Trade

Two Reasons for an Unfavourable Movement in the Terms of Trade

Define Export Price Index

Export Price Index Formula

Define Import Price Index

Import Price Index Formula

Definition of the Terms of Trade

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

Formula for the Terms of Trade

Terms of Trade (TOT) = (Export Price Index (XPI) / Import Price Index (MPI)) x 100

Two Reasons for a Favourable Movement in the Terms of Trade

Export prices rise relative to import prices

Import Prices fall relative to export prices

Two Reasons for an Unfavourable Movement in the Terms of Trade

Export prices fall relative to import prices

Import prices rise relative to export prices

Define Export Price Index

Measures the changes over time in the prices that a country's residents receive for goods and services sold to non-residents (the rest of the world).

Export Price Index Formula

Export Price Index (XPI) = (Current Year Price / First Year (Base Year) Price) x 100

Define Import Price Index

Measures the average change in prices paid by domestic buyers for goods and services purchased from other countries

Import Price Index Formula

Import Price Index (MPI) = (Current Year Price / First Year (Base Year Price)) x 100

What do you Discuss when Asked About - Factors that Affect the Terms of Trade, Including Changes in Commodity Prices

Factors Affecting the Price of Exports (XPI):

Commodity Prices

• Demand Side

• Supply Side

Composition of Trade

Factors Affecting the Prices of Imports (MPI)

Trade Liberalisation

Movements in the Australian Dollar

World Oil Prices

Discuss Commodity Prices as a Factor that Affects the Terms of Trade - Factors Affecting the Price of Exports (XPI)

Commodity Prices

Australia has a comparative advantage in primary commodities from the mining and agricultural sectors, including iron ore, coal, LNG, gold, wool, wheat, and beef. As such, commodity prices are the most important determinant of Australia’s XPI. When global commodity prices rise, Australia’s XPI increases, improving the terms of trade (ToT).

Demand Side: Global demand for commodities significantly affects export prices. Higher demand pushes up prices, raising the XPI and improving the ToT. For instance, strong Chinese demand for Australian iron ore and coal has historically driven up prices and boosted Australia’s XPI.

Supply Side: Global supply disruptions can raise commodity prices and, in turn, Australia’s XPI. For example, the Ukraine war (2022) constrained global energy and food supplies, causing energy prices to surge and lifting Australia’s export prices—resulting in a higher XPI and improved ToT

Discuss Composition of Trade as a Factor that Affects the Terms of Trade - Factors Affecting the Price of Exports (XPI)

Composition of Trade

Changes in the composition and weighting of exports within the XPI also influence export prices. Australia has shifted from predominantly rural exports to mineral and energy commodities such as iron ore, coal, and gold—products with relatively higher global prices. This structural shift has raised the average price of exports and therefore increased the XPI.
Additionally, growth in Elaborately Transformed Manufacturers (ETMs), such as pharmaceuticals and ICT equipment, supported by microeconomic reform (MER), has also contributed to XPI growth over time, as ETMs generally appreciate in price.

What do you Discuss when Asked About - Factors Affecting the Prices of Imports (MPI)

Trade Liberalisation

Movements in the Australian Dollar

World Oil Prices

Discuss Trade Liberalisation as a Factor Affecting the Prices of Imports (MPI)

Trade liberalisation—the removal of tariffs, subsidies, and quotas—has lowered Australia’s Import Price Index (MPI) by making imported goods cheaper. Reforms such as the phasing out of car industry tariffs and other microeconomic reforms (MERs) have reduced the cost of Elaborately Transformed Manufactures (ETMs) like cars and electronics.

Additionally, the rise of low-cost producers such as China has pushed down global prices for manufactured goods, further decreasing Australia’s MPI.

Discuss Movements in the Australia Dollar as a Factor Affecting the Prices of Imports (MPI)

Movements in the Australian Dollar (AUD) significantly affect the Import Price Index (MPI). When the AUD appreciates, it strengthens against other currencies, meaning fewer Australian dollars are needed to buy foreign goods. This lowers the cost of imports in AUD terms, decreasing the MPI.

Conversely, when the AUD depreciates, it weakens relative to other currencies, making imports more expensive in AUD terms and increasing the MPI.

Discuss World Oil Prices as a Factor Affecting the Prices of Imports (MPI)

World oil prices are a key determinant of Australia’s Import Price Index (MPI), as refined petroleum is one of Australia’s major imports. When global oil prices rise, Australia’s import costs increase, raising the MPI and reducing the Terms of Trade.

Higher oil prices also elevate energy and transport costs, which in turn increase the prices of other imported goods. For example, during 2022–24, the Ukraine–Russia war and Middle East tensions caused global oil price spikes, lifting production and import costs worldwide and increasing Australia’s MPI.

What do you Discuss when Asked About - The Primary Effects of Changes in Australia’s Terms of Trade

High Terms of Trade:

Increased Economic Growth (GDP Growth)

Increased Trade Balance & the Current Account Balance

The Exchange Rate Appreciation

Low Terms of Trade

Economic Growth (GDP Growth)

Trade Balance & the Current Account Balance

The Exchange Rate

Discuss Increased Economic Growth (GDP Growth) as a Primary Effect of Changes in Australia’s Terms of Trade - High Terms of Trade/Favourable Movement

A rise in Australia’s Terms of Trade (ToT)—often from higher commodity prices—stimulates economic growth by boosting export income and mining sector profits. Increased profitability encourages greater investment and production, generating more employment and raising GDP growth.

This growth is reinforced by the multiplier effect, as higher incomes lead to greater consumption and further expansion of economic activity.

Discuss Increased Trade Balance & the Current Account Balance as a Primary Effect of Changes in Australia’s Terms of Trade - High Terms of Trade/Favourable Movement

A rise in Australia’s Terms of Trade (ToT) increases the value of exports relative to imports, improving the trade balance—provided export and import volumes remain stable. Higher export values lift net goods and services credits, strengthening the current account balance (CAB).

For example, since 2020, surging commodity prices (especially iron ore) have raised Australia’s Export Price Index (XPI), boosting export earnings and improving both the trade and current account balances.

Discuss an Appreciation of the Exchange Rate as a Primary Effect of Changes in Australia’s Terms of Trade - High Terms of Trade/Favourable Movement

A rise in Australia’s Terms of Trade (ToT)—driven by higher export prices—increases demand for the Australian dollar (AUD) as foreign buyers purchase more Australian exports. This leads to an appreciation of the AUD.

A stronger AUD benefits consumers by making imports cheaper but can harm non-mining exporters by reducing their international competitiveness, creating a ‘two-speed economy’ (Dutch Disease).

For example, during the mining boom, soaring demand for commodities caused the AUD to appreciate, boosting mining output while sectors like tourism and manufacturing slowed due to the high exchange rate.

Discuss Decreased Economic Growth (GDP Growth) as a Primary Effect of Changes in Australia’s Terms of Trade - Low Terms of Trade/Unfavourable Movement

A fall in Australia’s Terms of Trade (ToT)—often due to declining export prices or rising import prices—reduces export income and profits in key sectors like mining and agriculture. Lower profitability discourages investment and production, leading to reduced employment and slower GDP growth.

This downturn is amplified by the multiplier effect, as falling incomes reduce consumption and overall economic activity. For example, when commodity prices decline, Australia experiences weaker export earnings, dampening growth across the economy.

Discuss Decreased Trade Balance & the Current Account Balance as a Primary Effect of Changes in Australia’s Terms of Trade - Low Terms of Trade/Unfavourable Movement

A fall in Australia’s Terms of Trade (ToT)—caused by lower export prices or higher import prices—reduces the value of exports relative to imports, worsening the trade balance. With lower export earnings, net goods and services credits decline, leading to a deterioration in the current account balance (CAB).

For example, when commodity prices fall, Australia’s Export Price Index (XPI) decreases, reducing export values and weakening both the trade balance and the current account balance.

Discuss a Depreciation of the Exchange Rate as a Primary Effect of Changes in Australia’s Terms of Trade - Low Terms of Trade/Unfavourable Movement

A fall in Australia’s Terms of Trade (ToT)—from lower export prices or higher import prices—reduces demand for the Australian dollar (AUD), causing it to depreciate.

A weaker AUD makes imports more expensive, raising the cost of imported goods and inputs for domestic production, while improving the competitiveness of exports. However, overall economic growth may still be constrained if the decline in export income outweighs these benefits. For example, a slump in commodity prices can reduce export revenue, lowering demand for the AUD and contributing to its depreciation.

What do you Discuss when Asked About - The Secondary Effects of Changes in Australia’s Terms of Trade

High Terms of Trade:

Increased Aggregate Demand (AD = C + I + G + (X-M)

Increased National Income & Living Standards

Increased Government Revenue 

Increased Inflation

Low Terms of Trade:

Decreased Aggregate Demand (AD = C + I + G + (X-M)

Decreased National Income & Living Standards

Decreased Government Revenue 

Decreased Inflation

Discuss Increased Aggregate Demand (AD = C + I + G + (X-M) as a Secondary Effect of Changes in Australia’s Terms of Trade - High/Favourable Terms of Trade

A rise in Australia’s Terms of Trade (ToT)—through an increase in the Export Price Index (XPI) relative to the Import Price Index (MPI)—boosts aggregate demand (AD = C + I + G + (X–M)). Higher export prices increase household incomes, stimulating consumption (C). Increased profits in the mining sector encourage investment (I), while higher export values raise net exports (X–M). This combined effect expands overall economic activity.

Discuss Increased National Income & Living Standards as a Secondary Effect of Changes in Australia’s Terms of Trade - High/Favourable Terms of Trade

A rise in Australia’s Terms of Trade (ToT)—driven by higher export prices—raises national income through increased profits in the mining sector and greater employment, leading to higher wages. This improves living standards, as the same volume of exports can now purchase a larger volume of imports.

For example, since 2020, rising commodity prices have increased Australia’s Export Price Index (XPI), boosting real national income and enhancing overall living standards.

Discuss Increased Government Revenue as a Secondary Effect of Changes in Australia’s Terms of Trade - High/Favourable Terms of Trade

A rise in Australia’s Terms of Trade (ToT) increases export receipts, boosting company tax revenue. Higher national income and employment also raise personal income tax collections. Together, these effects improve the government’s budget balance.

Succinctly Discuss Increased Inflation as a Secondary Effect of Changes in Australia’s Terms of Trade - High/Favourable Terms of Trade

A favourable rise in Australia’s Terms of Trade (ToT) raises national income through higher export receipts, stimulating investment and domestic spending. This increased demand can put upward pressure on prices, resulting in higher inflation.

Discuss Decreased Aggregate Demand (AD = C + I + G + (X-M) as a Secondary Effect of Changes in Australia’s Terms of Trade - Low/Unavourable Terms of Trade

A fall in Australia’s Terms of Trade (ToT)—when the Export Price Index (XPI) declines relative to the Import Price Index (MPI)—reduces aggregate demand (AD = C + I + G + (X–M)). Lower export prices reduce household incomes, decreasing consumption (C), while falling profits in the mining sector discourage investment (I). Additionally, weaker export values reduce net exports (X–M), collectively contracting overall economic activity.

Discuss Decreased National Income & Living Standards as a Secondary Effect of Changes in Australia’s Terms of Trade - Low/Unfavourable Terms of Trade

A fall in Australia’s Terms of Trade (ToT) reduces export receipts, lowering national income through decreased profits in the mining sector and employment. Lower incomes and wages reduce living standards, as the same volume of exports can now purchase fewer imports, diminishing the purchasing power of Australians.

Discuss Decreased Government Revenue as a Secondary Effect of Changes in Australia’s Terms of Trade - Low/Unfavourable Terms of Trade

A fall in Australia’s Terms of Trade (ToT) reduces export receipts, lowering company tax revenue. Declining national income and employment also decrease personal income tax collections. Together, these effects reduce the government’s budget balance and fiscal capacity.

Succinctly Discuss Decreased Inflation as a Secondary Effect of Changes in Australia’s Terms of Trade - Low/Unfavourable Terms of Trade

A fall in Australia’s Terms of Trade (ToT) lowers national income and domestic spending, reducing aggregate demand. This weaker demand puts downward pressure on prices, resulting in lower inflation.

Trends in Australia’s Terms of Trade over the Last 10 Years

Over the past decade, Australia’s Terms of Trade (ToT) have experienced significant fluctuations, with an overall favourable trend. Between 2014 and 2016, ToT declined due to a fall in the Export Price Index (XPI). Commodity prices, particularly minerals and oil, dropped as global supply increased—driven by higher mining investment—and global demand fell, notably due to a slowdown in China’s industrial growth. The Import Price Index (MPI) remained relatively stable, with minor decreases resulting from global oil oversupply, such as the 2016 surge in US oil production.

From 2016 to 2022, ToT rose sharply, driven by a significant increase in the XPI. Higher commodity prices, constrained global supply—such as the Brazilian dam collapse and the Ukraine war—and strong global demand, particularly from China’s large infrastructure projects, all contributed to this favourable movement. The MPI rose slightly due to high oil prices and rising freight costs, but the overall effect was a substantial improvement in Australia’s ToT, which peaked at 144.2 in the second quarter of 2022.

Between 2022 and 2024, ToT experienced an unfavourable movement as the XPI declined. Falling commodity prices, increased global supply of lithium, coal, and agricultural goods, and weaker global demand due to geopolitical tensions and slower Chinese growth all contributed to this decrease. The MPI had mixed effects: rising freight costs pushed import prices up, while falling oil prices slightly reduced import costs. By December 2024, ToT stood at 91.0, marking the first favourable movement in that year.