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Significance of the Terms of Trade

Economics (Year 12) - Terms of Trade

Christian Bien

Terms of Trade as an Indicator of Standards of Living

Real GDP has limits in measuring standards of living and that it also measures the quantity of exports. In the post-mining boom, net exports were still fuelling economic growth due to rises in the quantity of exports to maintain revenues, but the prices Australia received for the exports fell considerably. The RBA commodity price index more than halved from a peak of around 168 in the mining boom to 75 in 2015. The terms of trade can be used with real GDP to provide a more reliable indicator of standards of living. The sharply unfavourable fall in the terms of trade in the post-mining boom reflects the lower purchasing power of exports and lower mining profitability.

Terms of Trade as a Price Taker of Exports and Imports

Terms of trade data reveal that Australia is a price taker of exports and imports and that changes in Australian import and export habits are unlikely to change the prices of exports and imports. This is because Australia is a relatively small economy, with a small population compared to leading economies such as the United States or China. Australia is not significant enough to dictate the prices of exports and imports and has to adjust to price changes in the world economy.

Terms of Trade as an Indicator of Australia as a Two-Speed Economy

On the previous page, we explored the recent trends of the terms of trade and its links to commodity prices. The strong link between terms of trade and commodity prices indicates Australia's position as a two-speed economy, that changes in commodity prices will affect the economic activity of other sectors. Strong links to the terms of trade suggest Australia's standard of living is still strongly tied to changes in the mining sector. During the mining boom, the two-speed economy did reflect negatively on non-mining sectors, such as manufacturing, with high exchange rates reducing competitiveness, increased income inequality, higher inflation and higher wage rises.

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