How do movements in the TERMS OF TRADE affect the Australian economy?

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Quick summary

  • Australia’s Terms of Trade is the ratio between export prices and import prices for the economy. It is a ratio that involves prices, NOT volumes

  • An improvement in the Terms of Trade means export prices are rising faster than import prices. This is likely to lead to higher economic growth and rising living standards

  • An improvement in the Terms of Trade means import prices are rising faster than export prices. This could accelerate AND slow economic growth (confusing!) but would likely lower living standards

Thanks for the question Emily!

Big shout out to Emily S for her great comment below. 

[VCE is the final high school exam for students in Victoria.]

I read Emily’s question and it set my brain on fire. What a great question. Time for a comprehensive answer.

I’m going to go beyond Emily’s scope and discuss the impact of a favourable and unfavourable movement in the Terms of Trade. I hope she doesn’t mind.

What is the Terms of Trade?

It’s worth starting with a definition: the Terms of Trade (TOT) is the ratio of export prices to import prices. 

The terms of trade index = (export price index/import price index)*100

The TOT is a measure of the prices of exports and imports. It does NOT measure volumes. 


Think about it this way: 

  • Export prices represent income for an economy. If Australia sells exports to China, the goods or services go to China BUT the revenue arrives in Australia. Exports are an injection for the Australian economy.

  • Import prices represent a cost for an economy. If Australia buys imports from China, the goods or services arrive in Australia BUT income leaves Australia and arrives in China. In this way, imports are a leakage for the Australian economy.

What does the Terms of Trade show?

For an economy, exports represent revenue and imports represent costs.

If exports prices rise relative to import prices (so export prices rise faster than import prices), then a country can afford to buy more imports with the same volume of exports.

If import prices rise relative to export prices (so import prices rise faster than export prices), then a country can afford to buy less imports with the same volume of exports. 

Here’s a way to think about it. Export prices represent the amount of income Australia earns. If Australia earns more (export prices rise in relative terms), it can buy more stuff. And stuff = imports.

If Australia earns less (export prices fall in relative terms), it can buy less stuff. And stuff = imports.

Still confused about what the Terms of Trade means?

Check out my video setting out the concept.

What happens to the Australian economy when the Terms of Trade improves?

This is what’s known as a favourable movement in the TOT.

When the TOT improves, this means export prices are rising faster than import prices.

If export prices are higher, this means that Australia is earning more revenue from the sale of exports. This is because for every export sold, Australia receives more revenue (NOT PROFIT). 

When Australia’s TOT improves, this is usually due to higher prices for Australia’s natural resources and/or rural commodity exports. These rising prices send a signal to investors that demand for some of Australia’s exports is growing and it may be a good time to invest in the natural resource and rural sectors. If they invest now, they can hopefully earn a higher return as the growth continues.

So, there are a number of consequences from this change in the TOT:

  • There will be greater investment in Australia’s export sectors. This will increase capital inflows (foreign direct investment and portfolio investment) and lead to greater income outflows (as recorded in the Balance of Payments)

  • There will be greater demand for workers in the export sectors. Rising prices are due to higher demand; higher demand means that local firms may need extra workers to meet the rising demand. The extra foreign investment means they are extra resources to pay for more workers. As a result, employment could grow in the export sector.


In addition, a favourable movement in the TOT means that Australians can now buy more imports with the same volume of exports. This means Australians can afford more goods and services. As a result, living standards will improve.

Let’s go back to Emily’s question (not her real one but my expanded one)

How would a favourable movement in the TOT affect strong and sustainable economic growth and living standards?

Economic growth will rise. 

  • This is because export volumes are likely to be rising. Rising prices are a signal of higher demand. Exports are a component of aggregate demand. So: higher export sales, higher economic growth.

  • This is also because investment is likely to be rising. This is because more people will invest in Australia’s export industries when prices are rising. Investment is a component of aggregate demand. So: higher investment, higher economic growth.

And then living standards will be higher. This is because Australians can buy more imports (good and services) with the same volume of exports. This, in turn, is because exports command higher prices.

What happens to the Australian economy when the Terms of Trade worsens?

This is what’s known as an unfavourable movement in the TOT.

It is also referred to as a deterioration in the TOT.

When the TOT worsens, this means export prices are rising faster than import prices.

If export prices are relatively lower, this means that Australia is earning less revenue from the sale of exports. This is because for every export sold, Australia receives less revenue (NOT PROFIT). 

When Australia’s TOT deteriorates, Australians can buy fewer imports with the same volume of exports. This means that Australians can afford fewer imported goods and services. Therefore, living standards will worsen.

If Australia’s export prices are relatively lower, then there could be less interest in investing in Australia’s export sectors. This could reduce capital inflows (FDI and portfolio) and then reduce the size of income outflows.

Here’s a tricky part. If Australia’s TOT worsens, then Australia’s exports command relatively lower prices. This could actually make them more competitive. As a result, we could see greater demand for Australia’s exports. This would lead to greater sales of export volumes, which would boost aggregate demand and economic growth.

Basically: if the TOT worsens, then Australia’s exports are relatively cheaper. This means Australia could sell more and economic growth could improve.

Let’s go back to Emily’s actual question

How would an unfavourable movement in the TOT affect strong and sustainable economic growth and living standards?

Living standards would be lower. This is because Australians could afford fewer imported goods and services. Why? Because the same volume of exports can now purchase a smaller amount of imports.

For economic growth, there are some competing events.

  • Export volumes could be falling. This is because fallings prices are a signal of lower demand. Exports are a component of aggregate demand. So: lower export sales, lower economic growth.

  • Then investment could be falling. This is because less people will invest in Australia’s export industries when prices are falling. Investment is a component of aggregate demand. So: higher investment, higher economic growth.

  • But! If exports are relatively cheaper, then more people may wish to buy them. These exports are now more internationally competitive. This could increase export volumes and increase economic growth (over time).

  • Which factor would have a bigger impact? It would depend. But if you discuss both possibilities (higher and lower growth), this shows the marker you understand the complexity of this economic theory.

The connection between elasticity and the Terms of Trade

Elasticity of demand relates to the sensitivity of quantity demanded to a change in price.

If export prices rise, we would usually expect the demand for export prices to fall. This would be true for elastic goods. A small rise in price would lead to a large fall in quantity demanded.

But what happens if quantity demanded is inelastic? This means that a moderate rise in price may only lead to a small fall in quantity demanded.

We can consider Australia’s commodity exports as relatively inelastic. This is because they are high quality, highly sought after and available in large quantities. So even if the price of these exports rise, countries such as China will still want to buy large amounts of exports. 

So if the exports are relatively inelastic, even if the TOT improves, other countries will still purchase large volumes of Australia’s exports and economic growth will rise.

Ask your questions!

Thanks again to Emily for the question. Hopefully this answer helps. Send me your questions!

Now take a look at recent developments in Australia’s Terms of Trade in the video below.