Australias Terms of Trade - Essay Example

While the Budget factored in a decline in Australia’s terms of trade, the fall in global commodity prices over recent months has been larger than anticipated Contents Introduction 3 Question a 3 Question b 4 Question c 6 Conclusion 7 Reference 9 Introduction In the recent years the country of Australia enjoyed a firm and strong terms of trade yet volatile. It contributed in raising the level of real income which in turn stabilized the macroeconomic factors and reduced the persisting rate of inflation in the economy. The conjuncture got the support of dynamic and flexible private sector within the ever changing environment subjected to macroeconomic reform. The terms of trade can be regarded as the important economic measure. It can be defined as the ratio of prices of exports to prices of imports. The terms of trade reflects the capacity of any amount of exports to pay for the imports. A rise in this economic measure will enable Australia to buy more imports for fewer amounts of exports which in turn will increase the domestic real income. The volatility in terms of trade will induce volatility in the expenditures of the consumers as well as investment. Throughout history, Australia has been subjected to declining as well as volatile terms of trade. The situation changed after 1986. Since this year the country has been subjected to less volatile terms of trade while it is slightly upward rising trend. The terms of trade of the country has been positively correlated with economic growth of the globe. When the economic growth was strong, the terms of trade rose while the situation was just the opposite when the economic growth was slow. In the year 2000, the terms of trade of the country increased in spite of slowing down of the world economy. Question a There are two key components on the terms of trade of the country namely the global prices of the exports and imports of the country and the goods basket of the exports and imports. The country has the ability to affect the global prices the developments within the country also have the potential to influence the terms of trade. An increase in the global prices of coal compared with ICT goods will contribute in raising the terms of trade as the country is net exporter of coal and importer of ICT goods. There has been a wide positive correlation between the terms of trade and the exchange rate prevailing over that period. The nominal or the real exchange rate has fallen since the financial crisis of mid 1998. The import prices tend to be affected by the regional influences but the export prices are influenced by world prices. In the short run the prices of imports floored more swiftly than the export prices. The exchange rate got boosted. The uneven growth in productivity in tradable or in non-tradable goods sector contributed to the cause. After 1990s, the productivity growth has been rapid particularly in the sectors of finance and insurance. The second factor that acted to be the catalyst are strengthening of the U.S. dollar which was partly driven by capital flows which paved the path for the exchange rates to remain lower than the fundamental levels at least in the short period. The less volatility in the terms of trade contributed much to reducing the volatility of economic growth as well as in lowering the level of inflation. Since the new millennium the terms of trade took the upward rising curve. Over the past decade and a half the country experienced a gradual turn away from the relative price impulsive properties towards a varied and less unpredictable export base. The country is engaged in the process of exporting a broader range of rural goods and the exports of dairy products and vegetables have risen significantly over the years. Question b Three shocks to the terms of trade that can be identified are demand shock of the world that contributes to increase the prices of the exports, a shock that is specific to the commodity market and pushes the prices of the exports and the globalization shock that contributes to increase the price of exports as well as the global output but reduces the prices of the imports. The increase in the terms of trade tends to be expansionary but it may not always inflationary while the exchange rate provide surplus to the external shocks that shifts the terms of trade line. Inflation as well as output will take the upward rising curve following the demand shock but the impact is felt only in the short run due to higher interest rates and appreciation of real exchange rate. The Mundell-Fleming model is based on the IS and the LM curve (Sanders, n.d., p 1-3). Y=C+I+G+NX, where NX is the new exports and the other symbols hold usual denominations. The balance of Payments curve: , CA is the current account and KA is capital account surplus. Increased expenditure of the government will shift the IS curve to the right which results in incipient rise in the rate of interest and will put upward pressure on the exchange rate as foreign currency starts to flow in. the exchange rate is under the purview of the local authorities. If the worldwide interest rates rise, the BOP curve will shift upwards and capital will move out to take the advantage of the situation (RBA, 2012). The Australian dollar will depreciate under such cases and therefore the RBA must buy the home currency in order to accommodate the outflow of foreign currency reserves. The LM curve will shift to the right till it meets the IS and the BOP curves. Under conditions of perfect capital mobility the new Balance of payments curve will be parallel at the new rate of global interest and therefore the home rate of interest will be same as the global interest rate. An increase in the expenditure of government will force the RBA to supply local currency into the market in order to keep the exchange rate stable. The above figure shows the conditions of perfect capital mobility where BOP curve is horizontal. Question c Over the past decade the Australian Dollar has shown an upward trend against USD or TWI. Since June, 2010 AUD has appreciated 21% compared to USD. The rise in export prices of the commodities led to raise in the equilibrium exchange rates as bit increases the demand of Australian goods. The resources sector was benefitted with the increased investment to expand capacity while high terms of trade led to increased consumption spending. The key commodity prices for the country remained relatively lower in the early parts of the year. It has been anticipated that the terms of trade will follow the declining curve although it is expected to remain historically high. The financial markets have responded in positive fashion over the recent months which show progress in dealing with the financial problem in the continent of Europe (Garton, Gaudry and Wilcox, 2012., pp. 40-42). The low appetite for risk has kept the rates of interest at the much lower level. The banks of the country faced no hurdles in accessing funds while the capital markets enjoyed the corporations of the well rated banks of the country. The growth of the country has been close of what was anticipated and was driven by the capital spending in the resource sector. The strength of the growth of consumption expenditure was temporary while the investments in dwellings still remained subdued. The investments on non residential building were not strong either. The growth of employment has been moderate and maintained the low levels. According to the assessment of RBA the market was softened in the recent months (Parkinson, 2012.). The level of inflation has remained low. The consumer prices are getting affected with the introduction of carbon prices. The effect is expected to continue over the next year. The growth of credit has softened and the exchange rate has remained at higher levels than expected. The changes in the monetary policies will take some time to affect the economy given the decline in the prices of the exports and weak global conditions (RBA, 2012). Conclusion The above discussion focused on the reasons that led to movements in the terms of trade for Australia. From the discussion it was summarized that the prices of imports as well as exports played a major role in the movements of the terms of trade. Australia has been characterized as the country which has the potential to affect the global prices. The import prices took the steep declining curve and the exchange rate got boosted as the resultant. The strengthening of the U.S. dollar also played its part in movement of the exchange rate. The second question discusses the role of the Mundell-Fleming model on the economy of Australia. The shifts of the curve have been explained with the help of diagram. The reasons for such shifts have not been ignored as well. Finally the impact of monetary and fiscal policy on the decline on terms of trade has been discussed. The anticipation about the macroeconomic indicators is included in the discussion. Reference Garton, P., Gaudry, D. and Wilcox, R. 2012. Understanding the appreciation of the Australian dollar and its policy implications. [pdf]. Available at: http://www.treasury.gov.au/~/media/Treasury/Publications%20and%20Media/Publications/2012/Economic%20Roundup%20Issue%202/Downloads/03_Appreciation_of_the_Aust_dollar.ashx. [Accessed: 19th December, 2012]. Parkinson, M. 2012. MACROECONOMIC POLICY FOR CHANGING CIRCUMSTANCES. [online]. Available at: http://www.treasury.gov.au/PublicationsAndMedia/Speeches/2012/Post-Budget-ABE. [Accessed: 19th December, 2012]. RBA, 2012. International Market Operations. [online]. Available at: http://www.rba.gov.au/mkt-operations/intl-mkt-oper.html. [Accessed: 19th December, 2012]. RBA, 2012. Media Release. Available at: http://www.rba.gov.au/media-releases/2012/mr-12-30.html. [Accessed: 19th December, 2012]. Sanders, N. n.d. The Mundell-Fleming Model in the Small Open Economy. [pdf]. Available at: http://njsanders.people.wm.edu/101/Ch12_Handout.pdf. [Accessed: 19th December, 2012]. Read More