RDP 2011-05: Terms of Trade Shocks: What are They and What Do They Do? 4. Conclusion

This paper has provided empirical evidence on the effects of terms of trade shocks on inflation, output, interest rates and the real exchange rate in the Australian economy. Three shocks to the terms of trade were identified using sign restrictions in a VAR: a world demand shock that increases export prices, import prices and world output; a commodity-market specific shock that pushes up export prices, without a corresponding pick-up in world output; and a globalisation shock that increases export prices and world output, but reduces import prices.

The main conclusion of this paper is that increases in the terms of trade tend to be expansionary but are not always inflationary, with the exchange rate providing an effective buffer to external shocks that move the terms of trade. Inflation and output are found to rise following a world demand shock, but this effect is relatively short-lived due to higher interest rates and the appreciation of the real exchange rate. A commodity-market specific shock, meanwhile, is found to increase import prices, which results in higher trimmed-mean inflation on impact. The appreciation of the real exchange rate, however, offsets the impact on inflation, which is lower in subsequent periods. Finally, the globalisation shock results in lower domestic inflation on impact but also a depreciation of the real exchange rate, mitigating the deflationary effect in the quarter following the shock.

The terms of trade shocks were found to explain around two-thirds of the variation in the real exchange rate over the sample, but less than one-fifth of variation in the other domestic variables, providing evidence that the floating exchange rate is an important buffer to these shocks. The globalisation shock was found to be of more limited empirical importance in explaining movements in the modelled variables than the world demand shock or the commodity-market specific shock.