Terms of Trade

Flashcards on Terms of Trade in Economics

Terms of Trade

The ratio of export prices to import prices, indicating how many imports a country can purchase per unit of exports.

Terms of Trade Formula

(Index of Export Prices ÷ Index of Import Prices) × 100

Export Price Index

A weighted index that measures changes in the average prices received for a country’s exports over time.

Import Price Index

A weighted index that measures changes in the average prices paid for a country’s imports over time.

Favourable Movement (Terms of Trade)

Occurs when the index of export prices rises relative to import prices, meaning the country can buy more imports for each unit of exports.

Unfavourable Movement (Terms of Trade)

Occurs when the index of export prices falls relative to import prices, reducing the country’s purchasing power for imports.

Price taker

A country or firm that has no influence over the market price of the goods or services it sells; they must accept the prevailing world price.

Price maker

A country or firm that has significant control over the price of the goods or services it sells, often due to market power or dominance.

Commodity prices

Prices of raw materials and primary products such as iron ore, coal, and wheat.

Trade shocks

Sudden changes in global trade conditions (e.g., due to wars, pandemics, or policy changes) that impact export or import prices, and thus the TOT.

Purchasing power of exports

Refers to how much a country’s export revenue can buy in terms of imports; it rises when the TOT improves.

Volatility

The degree of fluctuation in prices over time.

The concept of the terms of trade (TOT)

Measure the ratio of a basket of export prices to a basket of import prices; used to measure the import purchasing power of exports.

The terms of trade (TOT) index

Measured using a method that involves comparing the average prices of a country's exports and imports over a specific period.

EXPORT PRICE INDEX

Measures changes in the prices of goods and services that are exported from a country.

Export Price Index Formula

(Current Period Weighted Average Price Exports/ Base Period Weighted Average Price Exports) x 100

IMPORT PRICE INDEX

Measures changes in the price of imported goods over time, expressed as a percentage of a base period.

Import Price Index Formula

(Current Period Weighted Average Price Imports/ Base Period Weighted Average Price Imports) x 100

FAVOURABLE (Terms of Trade Outcome)

Suggests that the terms of trade have improved and that the import purchasing power of exports has increased.

UNFAVOURABLE (Terms of Trade Outcome)

Suggests that the terms of trade have worsened and that the import purchasing power of exports has decreased.

IMPROVED (Terms used to describe tot changes)

If the terms of trade index increase, the change in terms of trade are said to have improved

WORSENED OR DETERIORATED (Terms used to describe tot changes)

If the terms if trade index falls, the change in the terms of trade are said to have worsened or deteriorated

Factors affecting the TOT

Australia is generally a 'price taker' as we are a medium-sized economy

Commodities

A raw material or primary agricultural product that can be bought and sold, e.g. iron ore, coal, wool, beef, LNG, gold

Manufactured goods

Most of Australia's imports are manufactured and intermediate goods (household appliances, equipment and machinery)

APPRECIATION (The exchange rate)

An appreciation in the exchange rate will create more favourable terms of trade.

DEPRECIATION (The exchange rate)

A depreciation of the exchange rate will create more unfavourable terms of trade.

MICROECONOMIC SUPPLY FACTORS (Factors affecting the price of exports)

Changes in technology, Supply shock from a natural disaster or other unexpected events, Changes in an overseas cartel/commodity agreement

MICROECONOMIC DEMAND FACTORS (Factors affecting the price of exports)

Change in tastes and fashion, Changes in world population growth, Changing world attitudes towards protectionism

MACROECONOMIC SUPPLY FACTORS (Factors affecting the price of exports)

Level of productivity, International competitiveness, Changes in taxation policies

MACROECONOMIC DEMAND FACTORS (Factors affecting the price of exports)

World economic growth, Change in incomes of trading partners

Price elasticity of commodities

Relates to the sensitivity of quantity demanded to a change in price.

MICROECONOMIC SUPPLY FACTORS (Factors affecting the price of imports)

Change in protectionism policies , Changes in an overseas cartel/commodity agreement, Changes in transportation costs

MICROECONOMIC DEMAND FACTORS (Factors affecting the price of imports)

Change in tastes and fashion, Rate of population growth

MACROECONOMIC SUPPLY FACTORS (Factors affecting the price of imports)

Level of productivity, International competitiveness, Changes in taxation policies

MACROECONOMIC DEMAND FACTORS (Factors affecting the price of imports)

Domestic economic growth, Change in domestic income

RBA Predications

Underestimate terms of trades during upswings, Overestimate the extent of falls in terms of trade during downswings.

The Global Financial Crisis - 2008 to 2009

The unfavourable position from an index of 174 to 162 was likely due to the falls in commodity prices which saw the index fall from approximately 137 to 80.

The Mining Investment Boom - 2009 to 2011

High growth in commodity prices from approximately 80 to 168 saw the export price index increased considerably relative to import prices, creating favourable terms of trade.

Post Mining Boom - 2012 to 2020

The fall in the commodity price index from approximately 168 to 75 saw export prices fall greatly relative to import prices.

2020 - Now

The recovery in commodity prices arising from the COVID-19 pandemic saw a boost to Australia's terms of trade.

Effects of the terms of trade on Australia’s CAD

When the terms of trade rise or fall (due to changes in our export prices relative to import prices), this will affect the values of both exports and imports and hence the size of Australia’s CAD.

Effects of the terms of trade on Australia’s exchange rate

Changes in the TOT have a powerful effect on the exchange rate for the Australian dollar.

Effects of the terms of trade on AD and domestic economic activity

The TOT is an aggregate demand-side factor that can affect the level of spending and economic activity.

TERMS OF TRADE AS AN INDICATOR OF STANDARDS OF LIVING

Real GDP has limits in measuring standards of living and that it also measures the quantity of exports.

TERMS OF TRADE AS A PRICE TAKER OF EXPORTS AND IMPORTS

Terms of trade data reveal that Australia is a price taker of exports and imports and that changes in Australian import and export habits are unlikely to change the prices of exports and imports.

TERMS OF TRADE AS AN INDICATOR OF AUSTRALIA AS A TWO- SPEED ECONOMY

The strong link between terms of trade and commodity prices indicates Australia's position as a two-speed economy, that changes in commodity prices will affect the economic activity of other sectors.