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The Terms of Trade: Not Dead Yet

The December quarter trade prices release saw the largest quarterly and annual increases in export prices since the current series began in the September quarter 1974, at 15.9% q/q and 54.9% y/y.  Import prices were up 10.8% q/q and 21.1% y/y, the largest annual increase since the December quarter 1985.  The merchandise terms of trade are up nearly 30% on a year ago.

How did Australia pull-off a further gain in the terms of trade against the backdrop of collapsing world commodity prices?  The depreciation in the Australian dollar over the quarter, which supported Australian dollar commodity prices.  This is a very good illustration of the role of a floating exchange rate in insulating the economy against external shocks. 

Given the magnitude of the external shock now confronting the Australian economy, the appropriate exchange rate response is massive depreciation.  In this context, US dollar strength is perfectly explicable, because weakness in the US economy is an external shock for the rest of the world. 

Unfortunately, this may see pressures for competitive devaluations and foreign exchange market intervention, not least on the part of the new US Administration.  This would be in sharp contrast to the highly principled stance the Bush Administration took against intervention in foreign exchange markets.  The new US Treasury Secretary, Tim Geithner, was a protégé of former Treasury Secretary Robert Rubin, who presided over massive intervention in foreign exchange markets.

posted on 24 January 2009 by skirchner in Economics, Financial Markets

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This is a very good illustration of the role of a floating exchange rate in insulating the economy against external shocks.

Hilarious.

I’m wondering how the rise in the Yen is insulating the Japanese economy against the external shock of collapsing export markets.

Posted by .(JavaScript must be enabled to view this email address)  on  01/26  at  02:38 AM


“How did Australia pull-off a further gain in the terms of trade against the backdrop of collapsing world commodity prices?  The depreciation in the Australian dollar over the quarter, which supported Australian dollar commodity prices.”

But the terms of trade is a relative price measure - the exchange rate increases the price of both exports and imports leaving the relative price virtually unchanged. 

I would say that the TOT stayed up because of contracting behaviour - contracts were signed at high prices, and so it takes time for low spot prices to feed into the TOT.

However, I agree with your point.  A floating exchange rate helps shift the burden/benefit of TOT shocks across the economy - rather than just hitting the export sector.  Furthermore it supports GDP by leading to a substitution away from imports and increasing the competitiveness of exports.

“I’m wondering how the rise in the Yen is insulating the Japanese economy against the external shock of collapsing export markets.”

The Yen and the $US are moving in the wrong direction - given the view that they are a “safe store of value”.  Sucks for them ...

Posted by Matt Nolan  on  01/26  at  08:49 PM


The Yen and the $US are moving in the wrong direction - given the view that they are a “safe store of value”.

How can the market be moving the value of the Yen and $US in the “wrong” direction?  If the market is doing it, surely it is the “right” direction.  If the direction is indeed “wrong” it *must* be due to interference by government because the market is always right.

Posted by .(JavaScript must be enabled to view this email address)  on  01/26  at  11:02 PM


“How can the market be moving the value of the Yen and $US in the “wrong” direction?  If the market is doing it, surely it is the “right” direction”

I should have had wrong in inverted comma’s, my apologises.  By wrong, I meant that the dollar is not moving in a way that smooths the economic cycle - the action of the market still makes sense given expectations and incentives, however it is just not very nice for the Japanese and US economies.

Posted by Matt Nolan  on  01/26  at  11:05 PM


“But the terms of trade is a relative price measure
- the exchange rate increases the price of both exports and imports leaving the relative price virtually unchanged.”

Yes, all else being equal, but if import prices are subject to a declining trend or slower growth rate that is independent of the exchange rate, as I think is the case for Australia and NZ, then we can still pull an improvement in the terms of trade out of the hat.

Posted by skirchner  on  01/27  at  03:02 AM


“if import prices are subject to a declining trend or slower growth rate”

relative to export prices right ...

NZ is experiencing export prices that are falling more quickly than import prices at the current time - hence why our TOT is falling. 

I thought that hard commodities were supposed to be the export that was getting relatively hammered dammit :)

Posted by Matt Nolan  on  01/27  at  03:22 AM


the action of the market still makes sense given expectations and incentives, however it is just not very nice for the Japanese and US economies.

Naturally.  Given a choice between the market being “wrong” and the market doing harm to the livelihoods of millions of Americans and Japanese, the libertarian will always choose the latter.

Insane.

Posted by .(JavaScript must be enabled to view this email address)  on  01/27  at  03:52 AM


“Naturally.  Given a choice between the market being “wrong” and the market doing harm to the livelihoods of millions of Americans and Japanese, the libertarian will always choose the latter.

Insane.”

I’m sorry - do you actually know what you are talking about.

The “market” in the sense we are discussing it is a descriptive mechanism for voluntary trade - not some etheral god that I worship.  I am using the idea of a market to describe what is happening so that I can understand it - rather than walking around a blog taking pots shots at people that don’t agree with my ideology.

If the entire world is collapsing then either exchange rates will not change or some will move in the “wrong” direction - it is unfortunate that people are losing jobs and income, but I don’t see how describing how it happens so that we can figure out how to improve outcomes is “insane”, it isn’t “the markets” fault you realise ...

Posted by Matt Nolan  on  01/27  at  03:58 AM


not some etheral god that I worship

My apologies, I assumed you drank the kool aid.  You will be lonely here then, because these guys really do believe the market always gets everything right, and the only time anything bad happens is because of “government interference” with the market.

You know this GFC thing?  Yep, all due to “government failure”.

Posted by .(JavaScript must be enabled to view this email address)  on  01/27  at  05:58 AM



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