External Stability

Terms of Trade

Another way of assessing Australia’s external stability is to examine the country’s terms of trade. That is, we can look at the ratio of export prices to import prices. When our exports become more valuable on the international market, we say that our terms of trade are improving. When our imports become more expensive relative to our exports, we would say that our terms of trade are getting worse. An example will help to make this clear.

Imagine a country that has only one export, and only one import. The country exports bread, and bread sells for $1 per loaf. We need to express this as an index, and so we will say that in year one the index was equal to 100 (so it can act as a basis for comparison for future years). In year two, bread sells for $1.10. In this instance, we would say that our export price index has increased to 110 – the price of our exports has increased by 10%.

The same country imports cars. In year one, cars cost $1,000 each. Obviously this can’t be directly compared to the price of bread, as the two are very different. However, if we say that the import price index in that year is equal to 100, then we are able to make the comparison. To take the example one step further, imagine that the price of cars falls to $950 in year two. This suggests that the import price index has fallen to 95 – but what does this mean for the terms of trade?

We can calculate the terms of trade in each year by using the following formula:

Therefore, in year one we would say that the terms of trade was equal to 100/100 *100 = 100. This is simply to provide us with a base year – everything after this will be compared to this year to determine whether we have seen an improvement or a worsening in the terms of trade.

In year two, we would calculate the index as follows:

As the figure is higher than in the previous year, we would say this represents an improvement in our terms of trade – our exports have increased in price relative to our imports.

This change could come about due to any number of supply or demand factors. If a severe drought restricted the supply of bread on the world market, the price of bread would increase. Similarly, if our bread developed a reputation for being amongst the best in the world, demand for our bread might increase. This could also contribute to a higher terms of trade. In Australia in 2005, demand for commodities and fuel from China resulted in a huge increase in demand for our exports, and our terms of trade increased significantly as a result. The recent trend can be seen in the graph below.

The current account deficit could move in either direction. More valuable exports may mean that the net merchandise and net services accounts show an improved outcome, and as such the balance on current account may be a smaller deficit. On the other hand, the appreciating currency may act to cancel this out, as imports appear even cheaper on the international market. In Australia between 2005 and 2007, the improving terms of trade acted to increase the value of the dollar, and the current account increased to the most significant deficit result recorded in many years.  During 2008/09 the terms of trade fell slightly, as global demand for commodities eased during the financial crisis that was seen at that time.

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