RDP 9508: Are Terms of Trade Rises Inflationary? 1. Introduction

As a small commodity-exporting economy, Australia is vulnerable to terms of trade shocks. These shocks have an impact on the general price level and, in the short run, affect domestic inflation.^[1] Stevens (1992), reviewing the history of Australian inflation, showed that throughout the post-war period of fixed exchange rates, a rise in the terms of trade was inflationary, while a fall reduced inflation. Since the adoption of a floating exchange rate, however, such a clear positive correlation between the terms of trade and inflation has diminished and, on at least one occasion, been reversed. Consequently, there have emerged conflicting views about the impact on inflation of a terms of trade shock. This conflict generates uncertainty about the way in which a recovery in Australia's terms of trade will affect the present environment of low inflation.

One view, put by Gruen and Shuetrim (1994) (henceforth, GS) is that, since the float of the Australian dollar, rises in the terms of trade reduce domestic inflation in the short run. After presenting a theoretical model, GS calibrate their model using empirical estimates for a large number of key parameters. GS do not, however, present any sensitivity analysis for their results.

This paper revisits the relationship between the terms of trade and domestic inflation. It addresses the question: how robust is the result that a rise in the terms of trade reduces domestic inflation in the short-run? To answer this question, we deal with a range of tricky empirical details to see if plausible changes to parameter values overturn this conclusion. We show, both analytically and empirically, that the exchange rate response to a change in the terms of trade is crucial to the inflation outcome. There is a ‘threshold’ exchange rate response, with a rise in the terms of trade being inflationary (other things being equal) if the associated rise in the real exchange rate is less than this threshold. By contrast, if currency appreciation exceeds this threshold, a rise in the terms of trade puts downward pressure on inflation.^[2]

The paper is organised as follows. Section 2 presents stylised facts about the link between terms of trade shocks and inflation. In Section 3, an analytical framework is developed which forms the basis of an empirical investigation of the impact of terms of trade shocks on inflation. Estimation and results are presented in Section 4. In Section 5, implications of the results are discussed and conclusions drawn.

Footnotes

It is generally assumed that, over the longer run, inflation is determined by the stance of domestic monetary policy. [1]

All of the conclusions assume ‘no policy response’, in the sense that the only variables influencing inflation are the terms of trade shock itself and market-induced exchange rate movements. [2]