RDP 2014-01: Macroeconomic Consequences of Terms of Trade Episodes, Past and Present 1. Introduction

The terms of trade – that is, the ratio of export prices to import prices – dictate the real purchasing power of domestic output and are a key determinant of a nation's economic prosperity. Large movements in the terms of trade can have important macroeconomic implications as relative prices and incomes change.

This paper places the current terms of trade boom in its historical context. It draws on a wide range of long-run macroeconomic and financial data, some of which pre-date Federation, to examine major terms of trade episodes in Australia. The paper highlights differences in the duration and the nature of the shocks driving these episodes. It also documents the prevailing policy settings and compares the macroeconomic outcomes.

Australia's terms of trade have increased markedly over the past decade, reaching a peak in September 2011 that was around 85 per cent above the previous century's average (Figure 1). This is, however, not the first time Australia's terms of trade have risen significantly. Since the mid 19^th century, Australia has experienced five major cycles in this key relative price. Most of these have originated from exogenous shocks associated with global economic developments, major conflict and drought. The most recent episode, for example, has been driven by the industrialisation and urbanisation of China and its effect on commodity prices, especially those of iron ore and coal. The current episode is also similar to others in that changes in the terms of trade have been driven mainly by movements in export prices. This reflects the fact that Australia has mostly exported rural and/or resource (minerals and energy) commodities, whose prices can be relatively variable, while it imports manufactures, which tend to have more stable prices.

Overall, the historical data indicate that large increases in the terms of trade have tended to be expansionary for the Australian economy. In general, during upswings GDP per capita growth has been stronger than the average growth over the previous decade; the rate of unemployment has fallen; economic indicators, such as business investment, and immigration have displayed procyclical characteristics.

On the other hand, downswings in the terms of trade have typically coincided with two years of below-average per capita GDP growth; an increase in the unemployment rate and other adverse macroeconomic outcomes. Typically, GDP per capita returns to its trend rate of growth by five years after the peak in the terms of trade.

The effects of terms of trade shocks on the economy have been influenced by government policy. Previous episodes suggest that, in a number of cases, policy responses did not fully moderate the macroeconomic outcomes. Today's policy settings and institutional frameworks, on the other hand, have assisted in producing stable and benign economic outcomes relative to past booms. Moreover, these settings and frameworks may help to facilitate the necessary adjustments as the terms of trade decline.

The rest of the paper is structured as follows. Section 2 documents the characteristics of the five major upswings and downswings in Australia's terms of trade. Section 3 examines the macroeconomic outcomes of each episode and notes both the common themes and differences. Section 4 contrasts the policy settings of the current episode with those of previous episodes. It highlights, for example, the current flexibility of the exchange rate, labour markets and institutional frameworks more generally, along with the different taxation structure that exists relative to previous cycles. Section 5 concludes.