As a small little open economy, international variables are incredibly important to us. The international rate of return, world prices for tradable goods, and the availability of external people, goods, and services, all have a disproportionate impact on us.
When discussing external prices, people constantly hear economists talk about the terms of trade (note, the wiki article is crap). During 2007 the Bank was (appropriately) lifting the official cash rate on the back of New Zealand’s climbing terms of trade. However, what all this meant, and what was going on didn’t really seem clear to everyone at the time.
The terms of trade tells us about the price of what we sell overseas relative to what we buy in. This is all very nice, but when people see this they might wonder why the Bank would want to react. To understand what was (and is) going on with our terms of trade we do need to differentiate between both sides of the ratio – export prices and import prices.
If export prices rise, our terms of trade will rise. This is all very good, we are getting paid relatively more for the stuff we sell, so we can buy more stuff from overseas – or we don’t have to expend the effort making as much stuff to get the same amount of stuff we got overseas as before.
When we look at monetary policy there are a few attributes of export prices to keep in mind:
- Export goods make up a very small proportion of domestic spending – so an increase in export good prices only has a small direct impact on measured consumer prices [domestic price level sits there].
- The lift in exporters incomes associated with the increase in export good prices is spent on both tradable and non-tradable goods. We can meet the increased demand for tradables from overseas – but the increased demand for non-tradables needs to be produced here. If we are already suffering from tight capacity (as we were in 2007) the increased demand for non-tradables simply pushes up non-tradable prices.
The Bank will largely view this type of situation as a demand shock – rising demand in the domestic economy is pushing prices up, all stemming from higher export incomes. This is what they responded to.
Export prices shocks are generally seen primarily as “demand shocks” as the direct impact on prices for domestic trade is minimal, while the impact on pressure for output is immediate … output leads prices.
If import prices fall, our terms of trade rises. This is also lovely, we can buy more stuff from overseas while selling the same amount of our stuff off.
When looking at monetary policy we can recognise:
- Import prices are significant with respect to domestic spending – as imports are either part of, or a direct substitute to many goods and services. So there is a significant downward price effect from the change in import prices [domestic price level drops].
- The cut in import prices makes imports more attractive, driving down demand for the domestic production of those goods.
- However, the increase in real incomes associated with lower import prices drives up demand for domestic production.
The net impact of import prices is far muddier.
We know that lower import prices will increase happiness/welfare, but depending on what effect dominates domestic production could fall or rise.
Well, the terms of trade is an important thing that gets thrown around a lot. It is a major structural variable, and the fact that our terms of trade appears to be (at least partially) structurally higher is a good thing. However, when we look at the near term adjustment of the economy to this shift it is important to look at where it has come from:
- Export prices have risen on structural demand for soft commodities
- Import prices have fallen on increasing productivity in manufacturing sectors (and possible subsidisation by some countries)
- Import prices have risen on structural demand for hard commodities.
Each of these shifts has a different impact on what the RBNZ would want to do with regards to setting short term interest rates, and although the “relative price” is all that may matter in the long run – in the short run the details of where this comes from is important for how they set policy.
Now in the long-run we don’t have the nominal rigidities driving the above result, so a higher terms of trade implies that the marginal cost of importing (relative to producing the good here) is lower – so we end up with higher imports, and a higher proportion of real consumption relative to real GDP. If the TOT is permanently higher, this is a fact we need to keep in mind when comparing everything we find to “historic averages” 😉