The terms of trade (ToT) measure the rate at which a country's exports exchange for its imports — essentially, how many units of imports a given quantity of exports will buy. For a commodity exporter like Australia, the terms of trade swing widely with world commodity prices and are a major driver of national income.
The terms of trade index
The ToT is expressed as an index relative to a base year:
Terms of trade index = (export price index ÷ import price index) × 100
A value above 100 means export prices have risen relative to import prices since the base year — an improvement. A rise in the index is an improvement (each unit of exports buys more imports); a fall is a deterioration.
Factors that affect the terms of trade
The dominant factor for Australia is commodity prices — especially iron ore, coal and gas — because these make up a large share of exports. Strong global demand (e.g. industrialisation in Asia) lifts export prices and improves the ToT; a slowdown lowers them. Import prices (manufactured goods, oil) and the exchange rate also matter.
Effects of a change
An improvement in the terms of trade raises national income, boosts mining profits and tax revenue, can appreciate the dollar and may improve the trade balance. A deterioration does the reverse. Because the ToT is volatile, it transmits global commodity cycles directly into the Australian economy.
Practise the index calculation and interpretation together.
Trace the chain
Strong demand for iron ore from Asia → export prices ↑ → export price index ↑ → ToT index ↑ (improvement) → national income ↑, mining profits and tax revenue ↑ → possible $A appreciation. Identify which step would reverse if commodity prices then fell.
1. Export price index = 118, import price index = 104. Calculate the terms of trade index and state whether it represents an improvement or a deterioration.
2. The following year the export price index falls to 95 and the import price index rises to 110. Recalculate the index and describe the change.
3. Explain how a rise in global demand for iron ore would affect Australia's terms of trade.
4. Outline two effects on the Australian economy of an improvement in the terms of trade.
5. Explain why Australia's terms of trade tend to be more volatile than those of a diversified manufacturing economy.