Terms of Trade & Exchange Rates

What do you talk about when asked about:

The Concepts of the Terms of Trade and the Terms of Trade Index:

Definition of the Terms of Trade:

Favourable Movement in the Terms of Trade (Increases the Terms of Trade):

Unfavourable Movement in the Terms of Trade (Decrease in the Terms of Trade):

Terms of Trade Index:

Definition of the Terms of Trade Index:

Formula:

Export Price Index:

Definition:

Formula:

Most Important Category in the XPI:

Examples:

Import Price Index:

Definition:

Formula:

Most Important Category in the MPI:

Examples:

The Concepts of the Terms of Trade and the Terms of Trade Index:

The Concept of the Terms of Trade

Definition of the Terms of Trade: An index measuring the relative movements in the prices of imports & exports.

→ It provides a measure of the quantity of imports a country can obtain from a given volume of exports.

Favourable Movement in the Terms of Trade (Increases the Terms of Trade):
A favourable movement (increase) in the Terms of Trade occurs because of two reasons:

→ Export prices rise relative to import prices

→ Import prices fall relative to export prices

When export prices are higher than import prices, standard of living increases (a given volume of exports now buys a larger quantity of imports) – the terms of trade is improving.

Unfavourable Movement in the Terms of Trade (Decrease in the Terms of Trade):
An unfavourable movement (decrease) in the terms of trade occurs because of two reasons:

→ Export Prices fall relative to import prices

→ Import prices rise relative to import prices

When import prices are higher than export prices, standard of living decreases (a given volume of exports now buys a smaller quantity of imports) – the terms of trade is worsening.

The Concepts of the Terms of Trade and the Terms of Trade Index:

The Concept of the Terms of Trade Index

Terms of Trade Index:

Definition of the Terms of Trade Index: A numerical figure comparing the price of Australian exports to the price of Australian imports.

Formula:

→ TOT = Export Price Index (XPI) / Import Price Index (MPI) X 100

Export Price Index:

Definition: Calculated by selecting representative groups of exports & determining the weighted average of their prices taking into account the relative importance of the item in the index.

→ Base year is always selected & assigned an index value of 100.

Formula:

→ XPI = Current Year Price / First Year Price X 100

Most Important Category in the XPI: Commodities

Examples: Iron Ore, Coal, Liquid Natural Gas & Wool

Import Price Index:

Definition: Calculated by selecting a range of representative groups of imports, determining the weighted average of their prices taking into account the relative importance of the item in the index.

→ Base year is always selected & assigned an index value of 100

Formula:

→ MPI = Current Year Price / First year (Base Year) Price X 100

Most Important Category in the MPI: Manufactured Goods

Examples: PMV’s & White Goods

What do you talk about when asked:

Factors that Affect the Terms of Trade, Including Changes in Commodity Prices:

Factors Affecting the Prices of Exports (XPI):

Commodity Prices:

Composition of Trade

Factors Affecting the Prices of Imports (MPI):

Trade Liberalisation:

Movements in the Australian Dollar (Exchange Rates):

World Oil Prices:

Factors that Affect the Terms of Trade, Including Changes in Commodity Prices:

Factors Affecting the Prices of Exports (XPI):

Commodity Prices:

→ Australia has a comparative advantage in the production of primary commodities form the mining & agricultural sectors.

→ Therefore, the most important determinant of Australia’s export price index is commodity prices.

• If commodity prices rise Australia’s export price index rises, ceteris paribus, so will the Terms of Trade.

→ Demand Side:

• Changes in global demand for commodities result in changes in the XPI.

• Higher demand for commodities increases the price of exports & the XPI.

• E.g., high demand from China or Australian commodities increases the prices of commodities increasing Australia’s XPI, therefore increasing the TOT.

→ Supply Side:

• Changes in the availability of commodities results in changes in the XPI.

• Negative supply side shocks decrease global supply & cause an increase in export prices increasing XPI.

• E.g., The Ukraine war restricted global supply & increased energy & food prices increasing Australia’s XPI & therefore increasing the TOT.

Composition of Trade:

→ Australia has shifted from rural exports to primary exports (iron ore, coal, gold) with relatively higher market prices compared to other exports.

• This increases the price of exports & the XPI, in turn increasing the TOT.

→ Additionally an increase in Elaborative Transformed Manufactures exports (pharmaceuticals & ICT equipment) facilitated by microeconomic reform increased XPI as EMTs tend to increase in price overtime.

Factors that Affect the Terms of Trade, Including Changes in Commodity Prices:

Factors Affecting the Prices of Imports (MPI):

Trade Liberalisation:

→ Decreasing import prices due to trade liberalisation (EMTs e.g., car industry) i.e., the removal of artificial trade barriers (e.g., tariffs, subsidies, quotas) between economies contribute to decreases in MPI increasing the TOT.

→ Emergence of fast growing, low-cost producers (comparative advantage) such as China have pushed down the prices of manufactured goods decreasing our MPI increasing the TOT.

Movements in the Australian Dollar (Exchange Rates):

→ When the AUD appreciates, it takes fewer Australian Dollars to purchase the same amount of foreign currency needed to pay for imported goods, decreasing the price of imports decreasing the MPI, increasing the TOT.

→ When the AUD depreciates, it takes more Australian Dollars to purchase the same amount of foreign currency needed to pay for imported goods, increasing the price of imports increasing the MPI, decreasing the TOT.

World Oil Prices:

→ One of Australia’s most important imports is refined petroleum.

→ If world oil prices increase, MPI increases, and ceteris paribus, decreasing the TOT.

• E.g., during 2022-2024 oil prices spiked due to the Russia-Ukraine war & tensions in the Middle East increasing the cost of production for manufactured goods decreasing MPI & the TOT.

What do you talk about when asked about:

Effects of Changes in Australia’s TOT:

Various positive effects of a high terms of trade/favourable movement in the Terms of Trade including;

• Increase in the Current Account Balance

• Appreciation of the AUD

• Increase in Aggregate Demand

Primary Effects:

Increase in Economic Growth (GDP Growth):

Increase in the Trade Balance & the Current Account Balance:

Exchange Rates:

Secondary Effects:

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

Increased National Income & Living Standards:

Increased Government Revenue:

Increased Inflation:

Primary Effects of Changes in Australia’s TOT:

→ There are various positive effects of a high terms of trade/favourable movement in the Terms of Trade including;

• Increase in the Current Account Balance

• Appreciation of the AUD

• Increase in Aggregate Demand

Primary Effects:

Increase in Economic Growth (GDP Growth):

→ An increase in the TOT due to higher commodity prices leads to an expansion in the economy, stimulating the business cycle.

→ Due to these higher commodity prices, profits in the mining sector rise, encouraging more investment in their sector to exploit the opportunity for greater profits.

→ This increases production creating more domestic employment (due to the increased demand for labour) opportunities, increasing productive capacity & GDP growth.

→ GDP growth will continue to increase due to the positive multiplier effect creating greater consumption & income in the economy due to increased employment.

Increase in the Trade Balance & the Current Account Balance:

→ There is a direct relationship between the TOT & Trade Balance.

→ An increase in the TOT increases export values, increasing the Trade Balance (only if the volume of exports & imports does not change).

→ Causing the Current Account Balance to increase as the value of credits (exports) increases marginally higher than the value of debits (imports) in Net Goods & Net Services (the Trade Balance).

→ E.g., Since 2020 XPI has increased significantly due to an increase in commodity prices increasing the value of iron ore exports to overseas markets increasing credits in net goods, increasing the Trade Balance & the Current Account Balance.

Exchange Rates:

→ Favourable TOT leads to an appreciation of AUD, as high export prices such as increased prices for Australia’s export commodities increases the demand for AUD (increased credits in the Trade Balance).

→ High AUD is beneficial for consumers as it reduces the prices of imported goods & services.

→ However, it creates a ‘two-speed’ economy (Dutch Disease) where producers & exporters in the non-mining sector are disadvantaged by the higher exchange rate.

• Due to a decrease in their international competitiveness.

• E.g., During the mining boom, ‘Dutch Disease’ resulted from Australia’s two-speed economy with strong growth & output in mining & slow output & growth in other sectors like tourism & manufactured goods.
  Increased demand for Australia’s commodities increased demand for the Australian dollar causing AUD to appreciate.
  While the mining sector thrived, other sectors struggled as appreciating AUD causes a lack of international competitiveness.
  Output & growth fell in most sectors, but Aus’ GDP growth increased due to the mining industry’s high output.

Secondary Effects of Changes in Australia’s TOT:

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

→ An increase in the XPI (increase in the TOT) relative to the MPI also increases aggregate demand – caused by:

• Increase in consumption (through higher incomes for households)

• Increase in Investment (due to higher profit incentives in the mining sector)

• Increase in net exports (since export values increase)

Increased National Income & Living Standards:

→ An increase in the TOT increases national income & living standards in Australia.

→ Higher profits from the mining sector & increased employment increases wages.

→ Living standards increase as the same volume of exports purchases a greater volume of imports.

→ Since 2020, Australia’s XPI caused an increase in real national income & increased Australia’s living standards.

Increased Government Revenue:

→ An increase in the TOT increases government revenue due to increased export receipts leading to increased company tax.

→ The increase in national income & employment results from a favourable terms of trade movement increases personal income tax payments to government.

→ The budget balance increases due to increased revenue.

Increased Inflation:

→ A favourable TOT can increase inflation.

→ A favourable terms of trade results in higher national income due to increased export receipts.

→ This has an expansionary effect on the domestic economy increasing the level of investment & spending putting pressure on prices (demand pull inflation).

What do you talk about when asked about:

Trends in Australia’s Terms of Trade Over the Last Ten Years:

Trends in Australia’s Terms of Trade:

2014 – 2016: Decrease/Unfavourable Movement in the TOT:

Fall in the XPI: Decrease in Australian Export Prices due to;

MPI was Stable with a Slight Increase due to:

2016 – 2022: Increase/Favourable movement in the TOT:

Increase in the XPI: Increase in the Price of Australia’s exports as a result of:

Slight Increase in the MPI: Increase in Import Prices due to;

2022 – 2024: Decrease/Unfavourable Movement in the TOT:

Decrease in the XPI: Decrease in export prices due to;

Slight Fall in the MPI: As a result of:

Trends in Australia’s Terms of Trade Over the Last Ten Years:

Trends in Australia’s Terms of Trade:

→ Australia’s TOT increased 1.7% from 89.4 in the September quarter 2024 to 91.0 in December 2024.

• This is the first favourable movement in 2024

→ The TOT reached an all time high of 144.2 in the second quarter of 2022 & a decade low of 69.8 in the first quarter of 2016.

→ Overall, the decade trend has been favourable.

2014 – 2016: Decrease/Unfavourable Movement in the TOT:

Fall in the XPI: Decrease in Australian Export Prices due to;

→ Decrease in Commodity Prices: Large fall in the price of mineral commodities – a decrease in oil prices decreased demand for energy substitutes such as coal & LNG which are major Australian exports.

→ Increased Global Supply of Major Mineral & Energy Commodities: Increased investment in mining companies globally increasing output in the global market.

→ Decrease in Global Demand: Slow down in China’s Growth in industrial production., decreasing demand for commodities.

MPI was Stable with a Slight Increase due to:

→ Main changes caused by global volatile price movements:

• E.g., In 2016 there was a large increase in US oil supply increasing global price of oil, as global supply exceeded demand.

2016 – 2022: Increase/Favourable movement in the TOT:

Increase in the XPI: Increase in the Price of Australia’s exports as a result of:

→ Increase in Commodity Prices: Energy commodity prices rose significantly reaching historical highs.

→ Decrease in Global Supply: Decrease in global supply of iron ore due to a dam collapse in Brazil & the Ukraine war resulting in sanctions against Russia.

• The Ukraine war also contributed to supply issues globally for agricultural goods & supply chain issues that constrained trade flows.

→ Increased Global Demand for Iron Ore: High demand from China as they demand imports to be used in large infrastructure projects.

Slight Increase in the MPI: Increase in Import Prices due to;

→ High Oil Prices: In 2021/2022 the price of Oil was at its highest in more than a decade due to sanctions placed on Russia – the worlds second largest oil producer.

→ Rising Freight Costs: Imported consumer capital & intermediate goods faced hgier transportation & production costs due to increased oil prices.

2022 – 2024: Decrease/Unfavourable Movement in the TOT:

Decrease in the XPI: Decrease in export prices due to;

→ Decrease in Commodity Prices: Commodity Prices have decreased including rural exports & iron ore.

→ Increased Global Supply:

• Good growing conditions increased supply of agricultural goods, increase in the supply of commodities (i.e. lithium & coal).

• Increase energy production taking advantage of higher prices.

→ Decrease in Global Demand: Weaker global demand due to geopolitical issues (e.g., Ukraine War, Middle East) & higher monetary policy slowing growth in China due to the China Property market slump.

Slight Fall in the MPI: As a result of:

→ Increase in Freight Costs: Reducing global demand has put pressure on freight supply raising shipping prices increasing the price of imports – increasing the MPI.

→ Decrease in Oil Prices: Fall in global demand particularly in China due to a slowdown in growth leading to a decline in global prices decreases the price of imports – decreasing the MPI.

What do you talk about when asked:

The Concept of an Exchange Rate, Including Australia’s Exchange Rate:

Exchange Rate Definition:

Calculating Exchange Rates Examples:

The Concept of an Exchange Rate, Including Australia’s Exchange Rate:

Exchange Rate Definition: The relative price of the Australian Dollar expressed in terms of another country’s currency (or in terms of the Trade Weighted Index), determined by supply & demand.

→ Exchange rates are necessary because exporting firms want to be paid in their own currency.

• E.g., an Australian wheat farmer wants to be paid in Australian dollars for their produce.

→ The foreign exchange market is the market in which the currencies of different countries are bought & sold.

→ Importers (in the foreign market) must convert their domestic currency into AUD currency to make payment.

→ Foreign exchange turnover in Australia is currently around AUD$160Billion a day, meaning AUD$160Billion worth of AUD is converted every day into other currencies.

→ Since 1983 Australia has used a floating exchange rate system (where the exchange rate fluctuates).

• This means price of the $AUD is decided by overseas currency buyers (demanders of $AUD) & local currency sellers (suppliers of $AUD).

→ In a fixed exchange rate (or pegged exchange rate), government determines the price of a country’s currency in terms of another’s currency.

• E.g., before 1971 the $AUD was pegged to the Great British Pound at a rate of GBPD0.40 = AUD1.00
  From 1971 it was pegged to the UAD until the AUD was floated in 1983 by the Hawke-Keating Government.

Calculating Exchange Rates Examples:

Assume 1AUD = 0.71 USD:

→ Calculate how much it would cost an Australian Citizen to purchase a computer from the US worth $2,000 USD:

• $2000 / 0.71 = AUD$2816.90

→ Express the exchange rate in terms of the USD:

• 1 / 0.71 = AUD$1.41,          therefore, USD1 = AUD1.41

→ State how much it would cost a US citizen to purchase a term of Australian education worth $3,000 AUD:

• 3,000 X 0.71 = USD$2,130

What do you talk about when asked:

The Concept of the Trade Weighted Index (TWI):

Trade Weighted Index Definition:

Highest Weighted Trading Partners:

Calculating the TWI:

The Concept of the Trade Weighted Index (TWI):

Trade Weighted Index Definition: Measures the Australian Dollar against a basket of 17 currencies of Australia’s main trading partners.

→ It reflects the global economic conditions & demonstrates the importance of our trading partners.

→ The Twi provides a broader measure of whether the Australian dollar is appreciating or depreciating against its trading partners currencies than frequently quoted bilateral exchange rates.

• It is a better measure of general trends in the exchange rate.

• Bilateral exchange rates tend to be more volatile whereas the TWI is often less volatile since the AUD is being compared to a basket of 17 currencies rather than just one.

Highest Weighted Trading Partners:

1.      Chinese Renminbi

2.      United States Dollar

3.      Japanese Yen

4.      European Euro

5.      South Korean Won

Calculating the TWI:

→ Based on a weighted geometric average of a basket of currencies chosen to account for at least 90% of Australia’s two-way merchandise & services trade.

→ Base period for the TWI is May 1970 = 100.

→ Weights are updated annually, with the TWI spliced together at every period in which the weights change.