What are the Factors Affecting Terms of Trade?

As the terms of trade are influenced by movements in export and import prices, the factors affecting terms of trade are the microeconomic and macroeconomic factors affecting the demand and supply of exports and imports.

Factors Affecting the Price of Exports

Microeconomic Supply Factors:

• Changes in technology - if new technology increases the output of exports, the prices of exports may fall

• Supply shock from a natural disaster or other unexpected events

• Changes in an overseas cartel/commodity agreement - e.g. OPEC cutting supply, increasing the cost of exports where oil is input in the production

Microeconomic Demand Factors:

• Change in tastes and fashion

• Changes in world population growth - high rates of world population growth could see higher demand for commodities to build infrastructure to meet growing populations, increasing export prices

• Changing world attitudes towards protectionism - If Australia's export partners engage in protectionist behaviour, then demand Australian exports will decrease, lowering export prices

Macroeconomic Supply Factors:

• Level of productivity

• International competitiveness

• Changes in taxation policies - tax reform, such as the cut in small business tax from 30% to 28.5%, will lower the cost of production, increasing supply and lowering export prices

• Changes in wages - higher wages will increase the cost of production, decreasing supply and increasing export prices

Macroeconomic Demand Factors

• World economic growth - higher world economic growth will increase demand for exports, raising the price of imports

• Change in incomes of trading partners

Factors Affecting the Price of Imports

Microeconomic Supply Factors:

• Change in protectionism policies - e.g higher tariffs, increasing the prices of imports

• Changes in an overseas cartel/commodity agreement - e.g. OPEC cutting supply, increasing the cost of imports where oil is an input in production

• Changes in transportation costs - Supply shock from a natural disaster or other unexpected events

Microeconomic Demand Factors

• Change in tastes and fashion

• Rate of population growth - a higher population could increase demand for imports

Macroeconomic Supply Factors

• Level of productivity

• International competitiveness

• Changes in taxation policies - for example, an increase in income tax will decrease disposable income available for expenditure on imports

Macroeconomic Demand Factors

• Domestic economic growth - higher rates of domestic economic growth will increase demand for imports as a business investment into imported capital goods increases and household consumption of imports will also increase.

• Change in domestic income - if households have increased incomes, then they can purchase more imports, increasing demand and import prices

Exchange Rate

The exchange rate has a direct influence on the terms of trade. Below are the effects of an appreciation and depreciation of the exchange rate. Appreciation: An appreciation in the exchange rate will create more favourable terms of trade. This is because the value of the currency will increase, meaning the purchasing power of imports will also increase. As exports are measured in local currency, not the price paid by overseas buyers, the export price index remains the same. Consider an appreciation of the dollar from$0.5 USD to $1 USD. An import of a US toy car costing $10 USD used to cost $20 AUD but will now cost $10 AUD, hence the price of imports has fallen, while export prices remain the same. Depreciation: A depreciation of the exchange rate will create more unfavourable terms of trade. This is because the value of the currency will decrease, meaning the purchasing power of imports will also decrease. As exports are measured in local currency, the export price index is unaffected.