National Income Terms of Trade - Assignment Example

MAE 202: T3 GUIDE TO ASSESSMENT 2: WRITTEN ASSIGNMENT. Terms of trade abbreviated as TOT is defined as the value of exports of a country relative to the value of its imports. It is determined or calculated by dividing the exports value by the imports value and then multiplying the result by 100. When the TOT of a country is below the 100% mark, the value indicates that there is increased capital going out to purchase imports that the capital coming in. On the other hand, a TOT value greater than 100% implies that the country is accumulating capital or more money is coming into the country from the exports. If the TOT of a country improves (rise above 100), it means that for each export unit sold it can be able to buy more units of the imported goods. Therefore, a rise or increase in the TOT creates a benefit in terms of the number of goods required to be exported in order to purchase a particular amount of imports. Improving TOT can also contain a valuable effect on the domestic cost-push inflation because an improvement shows falling import prices relative to the prices of exports. However, a country can undergo suffering in terms of the falling export volumes and a deterioration payments balance. Contrary to the indications of an increasing TOT, a deteriorating TOT (decreasing below 100) shows that a country needs to export increased amount of goods in order to buy a particular quantity of imports1 Australian TOT Between the year 1998- 1999 and the year 2008 to 2009, the TOT of Australia have undergone or went through an unprecedented rice of 75% indicating the alterations in both the composition and prices of traded services and goods. The prices of exports grew by 86% whereas that of imports grew by 9%. The increase or rise in the prices of exports was driven by the rise in metal ores and coal while the decrease in prices of most manufactured goods assisted in keeping the import prices down.2 In the year 2011, the TOT peaked rising to a level of 105% above the preciously prevailing values from the year 2002. This particular boom in TOT was attributed largely to the staggering high prices that the foreign buyers were paying for commodities such as iron, gas, and coal. Holding down of the import prices by the recorded high Australian dollar also boosted the TOT. In the month of December 2011 to march 2012 a decline of 9.8% was reported in the TOT. From this time, a free fall has been there in the Australian TOT a situation that economists argue is beginning to get serious. The data available for the period of June quarter on the Australian dollar and the prices of commodities suggests that the TOT decreased by another 7% bringing the total TOT decline in three consecutive quarters to approximately 16%. The TOT absolute level is still high on any particular long run assessment but the decline does not suggest that the country is at the low point of the cycle. The fall in the TOT presents a huge downside risk to the economy of Australia.3 The TOT and the TWER (trade weighted exchange rate), for the actual year 1998 to 2012 and also the indicative for the year 2012 to 2017 are displayed in the figure below. Sources: the exchange rate was retrieved from the Statistical Bulletin of the Reserve Bank of Australia while the TOT (terms of trade) was retrieved from the ABS Table 1 Cat. no. 5206.0 The Mundell-Fleming model is regarded as an open economy IS-LM version with inclusion of capital flows as a vital constituent of the model. The model is developed for the assessment of macroeconomic policy in a little open economy regarded as a price taker in import and export markets. The economy of Australia is definitely a small and open economy thus the application of this model to analyse the macroeconomic policy. In the last decade the imports and exports of services and goods of Australia were averaged at 37.3% of the GDP. The ISLM – BP model requires the capital mobility in order for the capital flows role to be activated. From the year 1980s both the capital outflows and inflows have increased substantially and averaged to 2.5% outflows and 6.5% inflows relative to the country’s GDP. The relatively high capital mobility degree and the openness and size of the economy provide the economy of Australia a better opportunity to contrast the Mundell-Fleming model predictions with the empirical data. In comparing the model of Mundell-Fleming and the empirical data, the joint behaviour of the nominal rate of interest, real output, prices, nominal rate of exchange, and nominal money are characterized by way of the VAR (vector autoregressive) model. The interpretation that is given to the TOT shocks in the model of VAR is based on the model of Mundel-Fleming version for a small and open economy, which is under flexible rates of exchange. Depending on this particular theoretical model, the shocks of the TOT identified are the commodity market particular or specific shock, a world demand, and a globalization shock. In order to distil the different global shocks that underlie the movements of TOT, the sign restricted VAR is estimated as follows:  Where dt and wt are endogenous domestic and world variables vectors, xt is an exogenous variables Vector, and B is the period impact vectors matrix of mutually uncorrelated domestic edt and world ewt disturbances.4 An optimistic world demand shock is linked to a pick-up in world economic activity and a rise in import and export prices while a positive/ optimistic commodity-market particular shock increases the export prices with no corresponding pick-up in the world economic activity. The globalization shock confines the increasing emerging economies integration with the notable ones being India and China, into the economy of the world. Increased globalization has been linked to a fall or decrease in the manufactured goods relative prices. Following the concentration of the Australian imports in the manufactured goods a likelihood of increasing the TOT is probable. Additionally, as more states integrate in to the global economy, raw materials demand increases thereby exerting an upward pressure on export prices. The direct impact or influence of an increasing TOT measured in isolation has been immense and regarded to be of the order of between 10 to 12 % as a GDP ratio from the year 2002. The trading benefits income effects of TOT are usually not included in the actual GDP but in actual sense they influence the real GDP. The broad flow-on effects of the TOT (terms of trade) into the real GDP have been extremely positive and this particular net direct influences contributes an added stimulatory effect. However, in the next five years beginning with the year 2013, the TOT has been predicted to fall, which will create a substantial deflationary force impacting the economy of Australia and removing some trading gains and slowing down the real GDP growth.5 The deflationary shock arising from the decreasing TOT will be balanced or offset to a given extent by the huge increase in the mining investments that have started and then scaled back in relation to the previously reported projections. In addressing or handling these given deflationary forces, the monetary policy limits needs to be recognized. In case the interest rates are significantly reduced over the coming one or two years, then the conventional monetary policy limits can be reached quickly as shown in the situation of the Australian comparator countries of North America and Europe. The expansionary monetary policy is not a possible or feasible outcome for offsetting fully the major deflationary impact already created. However, the devaluations of the exchange rate that can be relative substantially to the current levels of exchange rates can help in the long term. Therefore, in responding to the deflationary shock, the government needs to follow a supplementary expansionary fiscal policy having the acknowledgement of increasing the levels of debt and continuing the deficits. However, irrespective of the strong fiscal position of Australia, the level of this meticulous response is prone to be restricted by the low government revenue levels as a share of GDP, by sluggish increase in tax receipts from the resource projects and by the political concern regarding debt and deficits. Thus the real alternative to the political constraints on fiscal and monetary policy is an increased involvement of the government in providing bigger expenditure stimulus. Bibliography ABS, 2009. National Income Terms of Trade. [Online] Available at: [accessed 10 January 2013]. Denning, D., 2008. Terms of Trade Driving Runaway Australian Inflation. [Online] Available at:< http://www.dailyreckoning.com.au/terms-of-trade/2008/04/18/>[Accessed 10 January 2013]. Dornbusch, J., Fischer, S., and Startz, R. 2001. Macroeconomics, Eighth Edition. Boston, MA: McGraw Hill. Jääskelä, J., and Smith, P., 2011. Terms Of Trade Shocks: What Are They And What Do They Do?. Reserve Bank of Australia.[Online] Available at:< http://www.rba.gov.au/publications/rdp/2011/pdf/rdp2011-05.pdf>[Accessed 10 January 2013]. Koukoulas, S.,2012. Australia’s Terms of Trade are free-falling…. But how far will they go?.[Online] Available at: [Accessed 10 January 2013]. Read More