Australia: Terms of Trade - Essay Example

? Australia: Terms of Trade AUSTRALIA: TERMS OF TRADE Discuss the reasons for the main movements in Australia’s terms of trade over the last decade The terms of trade mean the quantity of imports, which are buyable via sale of a quantity of exports that is fixed. Improvements in a country’s TOT are positive for the country since it can buy more for a given export level. The TOT is influenced by the rate of exchange since a rise in the currency value of a country, brings its import domestic prices down but has no direct effect on the produced commodities for exports. The TOT is calculated using the formula; TOT= 100 x Average export price index/average import price index. If the export prices rise at a faster rate than prices of imports, then the TOT index rises, meaning less exports will be given up for a specific volume of imports. If the prices of imports rise at a faster rate compared to those of exports, TOT have deteriorated, and a larger export volume has to be sold in order to finance the importation of a given amount of services and goods. The TOT fluctuates according to changes in the prices of imports and exports with inflation and exchange rates influencing the direction of the TOT change. The graph below shows the Tot for Australia between 2002 and 2012; .  (Windsor Brokers, 2013: p1) The last month has seen a slow down in a trend that has been growing in the long term. This, however, is an anomaly rather than a trend. Central China has acted in favor of prosperity for Australia. Both TOT aspects in the exportation to China of coal and iron ore, as well as the importation of cheap Chinese goods, have influenced the TOT to a record positive level (International Monetary Fund, 2012: p43). The RBA refers to this as positive TOT shock, which is but one type of shock that is identifiable. Other shocks that can explain these are globalization shock, commodity-market specific shock, and world demand shock. A world demand shock that is positive is connected to an improvement in economic activity around the world coupled to an increase in import and export prices. Positive commodity-market specific shock improves prices of exports sans any corresponding improvement in economic activity around the world. Globalization shock, on the other hand, captures increasing emerging economy integration, especially that of India and China, into the global economy (International Monetary Fund, 2012: p44). An increase in globalization has been connected to a fall in relative prices for manufactured products. As imports from Australia are concentrated on manufactured products, this is expected to increase TOT. As more countries are integrated into the world economy, the demand increases for raw materials that exert a pressure export prices, which is associated with world output expansion. Global output has expanded over the past ten years, especially with China growing its economy by 8% for the tenth consecutive year (International Monetary Fund, 2012: p56). Additionally, global shock after manufacturing became globalized led to a reduction in the manufactured product prices, as well as a boost in raw material demand. This is what has seen the rise of the TOT for Australia in the last ten years. What could be the likely impact of a decline in the terms of trade on the Australian Economy? Analyze the impact on the macroeconomic variables in Australia, making use of the Mundell-Fleming model A decline in the TOT means that export prices fall in relation to imports. A decline in the TOT for Australia would lead to lower standards of living and a decreased importation ability. In the case of Australia, with its exportation of raw materials such as iron ore and coal and the importation of manufactured goods, a decline in TOT will result in Australia seeing the price of Iron ore falling in relation to that of manufactured products (Organisation for Economic Co-operation and Development, 2010: p135). This means that Australia will have to export moire iron ore and coal in order to get a similar quantity of manufactured products as it did before. A prolonged fall in the TOT could be viewed as a problem since it could result in falling standards of living coupled to declining gross domestic product. It is estimated that declining TOT cost countries, which exported oil between 1970 and 1997 the equivalent of one hundred and nineteen percent of their total annual GDP in revenues that were lost. It also became more difficult for them to pay off external debt as they had a reduced ability to earn increased foreign exchange (Organisation for Economic Co-operation and Development, 2010: p137). Concentration on primary products, like in Australia’s case, according to the hypothesis put forward by Prebisch and Singer, could see a decline as far as TOT is concerned. This is caused by decreased income elasticity demand since demand does not rise significantly in relation to income, and increased productivity that reduces the prices of the primary products coupled to increased supply. The average price of primary products like ores sold by countries in Africa from 1961 to 2001 fell by approximately seventy percent; this is in relation to the prices of goods from manufacturing oriented countries. This could also happen to Australia (Organisation for Economic Co-operation and Development, 2010: p138). A decline in the TOT does not necessarily have to be a negative thing. For instance, a decrease in TOT could happen because of devaluation in the rate of currency exchange. The devaluation could be meant to aid a country become more competitive, as well as increase the amount of exports to other countries (Yan Sun, 2012: p54). The UK, for instance, benefited in 1992 from a decrease in its terms of trade. The impact that a decrease in terms of trade will have will be dependent on demand elasticity. If there is the elasticity in demand, the decreased prices for Australia’s exports will lead to a larger percentage increase in the demand for its goods. Australia could also see a rise in TOT given the rise for manufactured commodities and food after 2008. It is vital to distinguish between declines in the short term and as far as terms of trade are concerned, and a short term decline in the TOT, as is being witnessed for Australia at the moment (Yan Sun, 2012: p55). A decline in the long term portends more serious effects for the country as they are reflected in the country’s living standards. This, however, is not forecasted for Australia. Following the MF model, or the Mundell and Fleming model, the diagram below can summarize the effects from monetary shocks on the terms of trade. While the Mundell and Fleming model is involved in exploring the effects of such an occurrence at the macro-level, it should be taking into serious consideration that monetary shock and its effects on the TOT would portend a different effect to industries that possess disparate imports/exports proportions of the total amount of outputs (Yan Sun, 2012: p67). Discuss the implications for monetary and fiscal policy of the decline in the terms of trade One of the most significant influences, historically, on the value of the Australian dollar has been the TOT. For instance, a decline in terms of trade for Australia as a result of declines in the price of primary commodities that make up a vital component of exports in Australia would provide a retraction impulse to the Australian economy because of the resulting income increase (Yan Sun, 2012: p110). The decreased demand for commodity inputs from the exporters would also see a resultant pressure from deflation. However, the strong correlation that exists between the Australian dollar and the TOT, as shown in the graph below, has varied with time. In the first fifteen years of the floating rate of exchange, the relationship, on average, was one for one. However, with time, it has weakened. The weakening has had implications for the model’s robustness, which seeks to come up with an estimate fair value for the currency (Yan Sun, 2012: p110). However, alterations in terms of trade continue to play a significant role in the explanation of changes to the real rates of exchange for the Australian dollar. (Reserve Bank of Australia, 2013: p1) While it is a fact that is widely accepted that any attempts to forecast rates of exchange are subject to difficulty, attempts made to model movements in rates of exchange, historically, have encountered mixed success rates. However, in comparison to other currencies, efforts made to model the rates of exchange for the Australian dollar in an after-float era have encountered relative success in the explanation of movements in the medium-term for the Australian dollar (Yan Sun, 2012: p113). This reflects the currency’s strong relationship with the TOT. While there is a possibility to identify determinants of the rates of exchange, it is vital to realize that the impact of the determinants can have varying effects over time. Specifically, while TOT has shown a relatively strong relation with the rates of exchange in the after-float era, evidence suggests that the relationship has gotten weaker over the last fifteen years. This was particularly so in the early 2000s when the TOT was rising coupled to substantial declines in real and nominal rates of exchange (Yan Sun, 2012: p114). This decline was reflected, in part, by a substantial appreciation of the $ at this time that was attributable to shifting portfolios by investors towards new technology assets away from Australia’s prevalent assets of the “old economy”. The choice of the regime of exchange rates, consistent with the attainment of increased control over monetary conditions domestically could also influence the manner in which the Australian economy copes with shocks from external forces, for instance, a sharp increase in the TOT, as experienced with the mining boom (Yan Sun, 2012: p116). A combination between independent monetary policy and flexible rates of exchange would result in high rates of exchange, as well as high interest rates in relation to the rest of the world, have both played a vital role in the preservation of Australia’s macro-economic stability. Reference List International Monetary Fund., (2012). Australia: Selected Issues. Washington: International MonetaryFund. Organisation for Economic Co-operation and Development., (2010). Australia 2010 : towards a seamless national economy. Paris : OECD. Reserve Bank of Australia., (2013). International Market Operations. Accessed from, www.rba.gov.au/mkt-operations/intl-mkt-oper.html January 15, 2013. Windsor Brokers., (2013) Australia Terms of Trade. Accessed from, www.tradingeconomics.com/australia/terms-of-trade January 15, 2013. Yan Sun, M., (2012). Potential growth of Australia and New Zealand in the aftermath of the global crisis. Washington: International Monetary Fund. Read More