The Effect of Movements in the Terms of Trade, Exchange Rate, and International Competitiveness on Domestic Macroeconomic Goals and Living Standards

1. Terms of Trade (TOT)

1.1 Definition and Measurement

The terms of trade (TOT) measures the ratio of the average price the world is prepared to pay Australia for our exports against the average price we pay the world for our imports. It represents the amount of imports that can be purchased with a unit of exports.

$$
Terms \ of \ Trade \ Index = \frac{Index \ of \ Export \ Prices}{Index \ of \ Import \ Prices} \times 100
$$

• A TOT index above 100 indicates that export prices are relatively higher than import prices compared to the base year.
• A TOT index below 100 indicates that export prices are relatively lower than import prices compared to the base year.

1.2 Factors Affecting TOT

• Commodity Prices: Fluctuations in global commodity prices, particularly for resources like iron ore and coal, significantly impact Australia’s TOT.
• Production Costs in Trading Partners: Changes in production costs in countries that Australia trades with affect the prices of imports and exports.
• Global Demand and Supply: Shifts in global demand and supply conditions for goods and services influence their prices, thereby affecting the TOT.

1.3 Impact on Macroeconomic Goals and Living Standards

KEY TAKEAWAY: A favorable TOT is generally beneficial for Australia, leading to increased economic growth, improved living standards, and a stronger current account. An unfavorable TOT has the opposite effect.

2. Exchange Rate

2.1 Definition and Measurement

The exchange rate is the price of one country’s currency expressed in terms of another country’s currency.

• AUD/USD: The number of Australian dollars required to purchase one US dollar.
• Appreciation: An increase in the value of the Australian dollar relative to another currency.
• Depreciation: A decrease in the value of the Australian dollar relative to another currency.

2.2 Factors Affecting Exchange Rate

• Relative Interest Rates: Higher interest rates in Australia attract foreign investment, increasing demand for the AUD and causing it to appreciate.
• Commodity Prices and TOT: Higher commodity prices and improved TOT increase demand for the AUD, leading to appreciation.
• Demand for Exports and Imports: Increased demand for Australian exports increases demand for the AUD, causing it to appreciate. Increased demand for imports increases the supply of AUD on the foreign exchange market, depreciating the AUD.
• Foreign Investment: Increased foreign investment in Australia increases demand for the AUD, leading to appreciation.
• Relative Rates of Inflation: Lower inflation in Australia relative to other countries makes Australian goods and services more competitive, increasing demand for the AUD and causing it to appreciate.
• Credit Ratings: A higher credit rating increases confidence in the Australian economy, attracting foreign investment and causing the AUD to appreciate.
• Speculation: Expectations about future exchange rate movements can lead to speculative buying or selling of the AUD, influencing its value.

2.3 Impact on Macroeconomic Goals and Living Standards

EXAM TIP: Be sure to analyse both the short-term and long-term effects of exchange rate movements. Also, consider the magnitude of the change and the specific industries affected.

3. International Competitiveness

3.1 Definition

International competitiveness refers to the ability of Australian businesses to profitably produce and sell goods and services in international markets at a price and quality that is attractive relative to overseas competitors.

3.2 Factors Affecting International Competitiveness

• Productivity: Higher productivity reduces production costs per unit, making Australian goods and services more competitive.
• Production Costs: Lower production costs (e.g., wages, energy, raw materials) make Australian goods and services more competitive.
• Availability of Natural Resources: Abundant and readily available natural resources can provide a competitive advantage.
• Exchange Rates: A lower exchange rate (depreciation) makes Australian goods and services cheaper for foreign buyers, increasing competitiveness.
• Relative Rates of Inflation: Lower inflation in Australia relative to other countries makes Australian goods and services more competitive.
• Technological Advancements: Innovation and adoption of new technologies can improve productivity and product quality, enhancing competitiveness.
• Regulation: Government regulations can affect production costs and efficiency, impacting competitiveness.

3.3 Impact on Macroeconomic Goals and Living Standards

COMMON MISTAKE: Students often confuse international competitiveness with productivity. While productivity is a factor influencing competitiveness, it is not the same thing. Competitiveness is the outcome of various factors, including productivity, costs, and exchange rates.

4. Interrelationships

• Movements in the TOT can affect the exchange rate. For example, an increase in the TOT due to higher commodity prices can lead to an appreciation of the AUD.
• Changes in the exchange rate can affect international competitiveness. A depreciation of the AUD can make Australian goods and services more competitive.
• Increased international competitiveness can improve the TOT by increasing demand for Australian exports.

VCAA FOCUS: VCAA often presents scenarios where multiple factors (TOT, exchange rate, competitiveness) change simultaneously. Students need to be able to analyze the combined effect of these changes on the macroeconomic goals and living standards.