Terms of Trade Shocks: What are They and What Do They Do?

This paper describes and quantifies the macroeconomic effects of different types of terms of trade shocks and their propagation in the Australian economy. Three types of shocks are identified based on their impact on commodity prices, global manufactured prices, and global economic activity. The first two shocks, a world demand shock and a commodity-market specific shock are fairly standard. The third shock, a globalisation shock that may result, for instance, from the increasing importance of China, India and eastern Europe in the global economy is more novel. The globalisation shock is associated with a decline in manufactured prices, a rise in commodity prices, and an increase in global economic activity. Determining the underlying source of variation in the terms of trade is shown to be important for understanding the impact on the Australian economy as all three shocks propagate through the economy in different ways. The relative contribution of each shock to inflation, output, interest rates, and the exchange rate has also varied over time. The main conclusion of the paper is that a higher terms of trade tends to be expansionary but is not always inflationary. A key result is that the floating exchange rate has provided an important buffer to the external shocks that move the terms of trade.