RDP 9508: Are Terms of Trade Rises Inflationary? 2. Stylised Facts

Figure 1 shows the relationship between inflation and the terms of trade in Australia during three episodes in which the terms of trade exhibited substantial change.^[3]

The largest terms of trade shock occurred during the early 1950s (see panel I). At this time, the Korean War induced a wool price boom and, in consequence, there was a record increase in Australia's export prices. With a fixed exchange rate in operation, the attendant surge in income and money balances quickly translated into record inflation. Subsequently, when wool prices collapsed and the terms of trade fell, there was a corresponding fall in the inflation rate.

A similar relationship between the terms of trade and inflation was evident during the 1970s, although the magnitude of the change was significantly less than in the 1950s (see panel II). This time, the terms of trade rise was driven by a broadly-based commodity price boom, including a quadrupling of the US dollar oil price. Again, with a fixed nominal exchange rate, the resultant increase in income and money balances fed into domestic inflation. Similarly, as the terms of trade fell, so too did domestic inflation.^[4]

The two experiences provided powerful evidence for the view that the terms of trade and inflation have a strong positive correlation.^[5] The income effects of changes in the terms of trade were clearly manifested and, with a lag, were seen to operate on domestic prices. However, with the floating of the exchange rate in December 1983, this conventional relationship appeared to break down.

In the mid 1980s, the terms of trade fell sharply but, for the first time, such a fall did not reduce inflation. It was instead accompanied, at least initially, by an acceleration of domestic inflation (as shown in panel III). The currency depreciated by more than required to cushion the negative income effect of the fall in the terms of trade. In fact, the currency may have depreciated by more than can be explained by economic fundamentals.^[6] Consequently, it increased the domestic price of traded goods (in particular imports) and a negative correlation between the terms of trade and inflation emerged. This outcome clearly distinguished the experience of the mid 1980s from that in earlier episodes.

During the rest of the 1980s and the early 1990s, the terms of trade and inflation again moved in line with each other (panel III), suggesting perhaps that the experience of the mid 1980s was an aberration; a consequence of exchange rate ‘overshooting’.^[7] However, despite an apparent return to the historical relationship between the terms of trade and inflation, it is premature to conclude that, as a general case, a fall in the terms of trade reduces inflation while a rise is inflationary. As ever, it is difficult to disentangle the influence of the terms of trade on this outcome from the effect of the business cycle and domestic policy settings. This task is especially difficult when there has not been a discrete shock of the magnitude witnessed in earlier episodes. Thus the question remains: with a floating exchange rate, are rises or falls in the terms of trade inflationary?

The following section discusses the mechanisms by which changes in the terms of trade have an impact on inflation. A simple model is developed with which to demonstrate the different inflation outcomes under fixed and floating rate regimes.

Footnotes

Inflation is measured by the four quarter ended change in the consumption deflator. [3]

It should be acknowledged that while the exchange rate was not freely floating during the 1970s, it was variable. It was revalued several times as the terms of trade rose, and devalued as they fell. However, these currency realignments were not sufficient to insulate the economy from significant changes in the world price of traded goods (Blundell-Wignall, Fahrer and Heath 1993, pp. 35–36). [4]

Blundell-Wignall and Gregory (1990) provide a detailed discussion of this view. [5]

Blundell-Wignall et al. (1993) provide estimates of the extent to which the actual value of the currency departed from its equilibrium value, where the equilibrium value is a function of the terms of trade, real interest rate differentials and net foreign liabilities. See also O'Mara, Wallace and Meshios (1987) for an analysis of the Australian dollar during the mid 1980s. [6]

Where overshooting is defined here as the exchange rate moving by more than is justified by fundamentals, rather than as defined by Dornbusch (1976). [7]