Terms of Trade Notes
Terms of Trade
Definition
Australia's terms of trade (TOT) is calculated as the ratio of export prices to import prices.
It represents the average price paid for exports relative to prices paid for imports.
Alternatively, it's the amount of imported goods that can be purchased with a unit of exported goods.
Measurement
The TOT is measured using an index with a base year (index equals 100) for comparison.
Formula: Terms of Trade Index (TOT) = \frac{Export Price Index}{Import Price Index} × 100
The export price index measures changes in the average prices of a basket of Australian exported goods, weighted by their relative importance in trade (e.g., coal and iron ore have higher weightings).
The import price index measures changes in the average prices of imported goods, weighted by their relative importance.
An increasing index implies Australia is receiving relatively more for its exports, while a decreasing index implies it's receiving relatively less.
Favorable vs. Less Favorable TOT
More Favorable TOT:
Export prices rise faster or fall less than import prices.
A nation can purchase more imports with a given unit of its exports.
Less Favorable TOT:
Export prices rise more slowly or fall more quickly than import prices.
A nation can purchase fewer imports with a given unit of its exports.
Favorable Terms of Trade
Exists when average prices received for exports are relatively higher than average prices received for imports.
The TOT rises or becomes more favorable when export prices rise faster, or fall less, than import prices.
Occurrences:
Export Price Index Increases while the Import Price Index remains the same.
Export Price Index Increases by more than the Import Price Index increases.
Export Price Index Decreases by less than the Import Price Index.
Export Price Index stays the same while the Import Price Index decreases.
Unfavorable Terms of Trade
Exists when average prices received for exports are relatively lower than average prices received for imports.
A less favorable movement occurs when export prices rise more slowly, or fall more quickly, than import prices.
Occurrences:
Export Price Index decreases while the Import Price Index remains the same.
Export Price Index decreases by more than the Import Price Index decreases.
Export Price Index increases by less than the Import Price Index.
Export Price Index stays the same while the Import Price Index increases.
Movements in TOT
Favorable Movement: TOT is increasing (export prices increasing relative to import prices).
Unfavorable Movement: TOT is decreasing (export prices decreasing relative to import prices).
A favorable movement doesn't necessarily mean the actual TOT is favorable (index > 100), and vice versa.
Example: TOT moving from 95 to 98 is a favorable movement but still an unfavorable TOT.
Example: TOT moving from 106 to 103 is an unfavorable movement but still a favorable TOT.
Causes of Changes to the TOT
Impacted by changes to global demand and/or global supply.
Global Demand
The level of world demand for Australia’s exports influences export prices and TOT.
Decrease in global demand for Australian exports (e.g., coal, iron ore) leads to lower export prices, potentially depressing the TOT.
Increase in global demand for exports leads to higher export prices, potentially increasing the TOT.
Increased global production, particularly from China and India, and government stimulus during Covid increased global demand for commodities, increasing commodity prices and the export price ratio.
Global Supply
Increased supply puts downward pressure on commodity prices.
China's ability to reduce production costs has led to lower-priced imported goods, helping Australia to keep the import price index lower, thus improving its TOT.
Mine closures (e.g Brazil) reduced iron ore supply; disruptions from the war in Ukraine impacted commodities like oil, gas, and wheat, creating shortages and placing upward pressure on global prices, benefiting Australian exporters.
Factors Impacting TOT
Australia is a large trader in commodities (raw materials like coal, iron ore, and grains).
Changes in commodity prices due to changing demand and/or supply impact the TOT.
Commodity Prices
Increased commodity prices (due to increased world demand or falling global supply) improve the TOT.
Exporters receive higher prices for exports like coal, iron ore, and gas (high weightings in the export price index).
Falling commodity prices generally cause an unfavorable movement in the TOT as exporters receive relatively lower prices compared to prices paid for imports.
Costs of Production in Major Trading Partners
If trading partners (e.g., China) lower production costs, they can offer cheaper imports, improving Australia's TOT.
Australia is a net importer of technological devices, so technological advancements have led to cheaper imports, contributing to a more favorable TOT.
Higher costs of production would see trading partners offer more expensive imports, worsening Australia's TOT (due to higher import prices relative to export prices).
Effects of Terms of Trade
Relationship to Aggregate Demand
The TOT is an aggregate demand-side factor affecting spending and economic activity.
Components are net exports (X-M).
A rise in the TOT tends to boost the value of net exports and Gross National Income. Any given volume of output exported can be sold for a higher price.
Exporting businesses may be able to offer higher wages to workers or pay higher dividends to shareholders. This tends to increase consumption C. Businesses may also invest in expansion boosting I spending.
Businesses may also invest in expansion boosting I spending. This increases AD and domestic economic activity.
A decline in the TOT tends to weaken the value of export sales relative to import spending, slowing AD and economic activity.
Impact on Current Account
A fall in the TOT tends to cause the CAD to rise or the CAS to fall due to weaker demand for exports and dearer global prices paid for imports.
A rise in the TOT usually results in a decrease in the CAD or an increase in the CAS due to higher prices causing a rise in the value of credits for exports relative to debits for imports.
Impact on the Exchange Rate
As commodity prices rise, exporters receive more money, increasing demand for the AUD and raising its value.
Where export prices fall there will be less demand for AUD to pay for exported goods and services and therefore the AUD may also decrease.
If import prices rise, Australians will have to convert more AUD to foreign currency to pay. This increases the supply of AUD in the market and causes a depreciation.
If import prices fall, Australians will have to convert less AUD to foreign currency to pay. This decreases the supply of AUD in the market and may cause an appreciation.
Impact on Living Standards
When prices for exported commodities rise, the TOT improves, increasing profits and incomes for exporters.
This increases purchasing power, consumption, and investment.
Increased profits increase access to goods and services, increasing material living standards.
It also allows more taxation on larger profits to provide essential services like health and education improving quality of life factors like literacy and increased life expectancy
Falling import prices may benefit producers using imported resources, reducing unit costs and increasing profits.
Impact on Domestic Goals
When prices for exported commodities rise, improving the TOT, this increases profits and incomes. This increase is an increase in real national disposable incomes (GDI).
With the increase demand this increase aggregate Demand and GDP, producers lift production to meet rising demand this results in a boost in economic growth.
With increases in growth this could place downward pressure on unemployment.
If prices for imported goods falls relative to exports this may also have benefits for those producers using imported resources for production, reducing unit costs (improving AS conditions) and therefore increasing profits. This also reduces pressure on prices (inflation) and increases international competitiveness.
If world prices for our exports rise in conjunction with an increase in demand (X) this may cause inflation due to capacity restraints on production and the increases in (C) (I) due to higher national income (GDI) generated by higher export prices.
Current Trends
Improvements in the TOT typically occur as a result of increasing prices for Australia’s commodity exports, specifically iron ore, thermal coal, coking coal, and natural gas.
In recent years, import prices have generally risen more slowly than export prices (despite rising global inflation) contributing to the rising TOT.
In June 2022 the TOT reached a high of 107.7, largely due to high commodity prices received due to large demand for our commodities as we came out of Covid lockdowns and economies started to recover.
The unfavourable movement in TOT contributed to Australia’s deteriorating current account balances in recent years.
In December 2024, the TOT was 91 and this represented a deterioration in the TOT from twelve months previously in December 2023 (95.1).
A weaker TOT will reduce Net Export earnings and contribute to a further weakening of Australia’s economic growth and employment conditions.
It will also contribute to a depreciation of the exchange rate as less AUD will be demanded to pay for our exports as the prices have fallen, relative to prices paid for imports.