Story: Prices and inflation

Page 6. Terms of trade and the exchange rate

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Two measures of the ways in which price changes for New Zealand goods and services intersect with world prices are the terms of trade and the exchange rate.

Terms of trade

The terms of trade index is calculated by dividing the index of prices New Zealand receives for goods it exports, by an index of prices New Zealand pays for goods it imports. This gives a clearer picture of the balance of imports and exports, for example the number of tonnes of butter or timber that New Zealand has to export in order to import a bus or a barrel of oil.

Terms of trade directly affect New Zealanders’ standard of living. When the terms of trade fall, more products have to be exported to pay for imports – either less production is available for domestic consumption, or imports have to decline. There was a sharp decline in the terms of trade after the oil price shock in the early 1970s, and the terms of trade only returned to the 1957–74 average in 2008. In the early 2000s the terms of trade were more stable than in previous decades.

Exchange rate

The exchange rate is the price – or rate – at which the New Zealand dollar is exchanged for other currencies. It is expressed either as the number of foreign currency units that $1 can buy, or as the number of New Zealand dollars that are required to buy one unit of a foreign currency. In August 2008 NZ$1 bought 38 British pence, so it cost about $2.63 to buy one British pound.

Floating exchange rate

Until the 1980s New Zealand currency was fixed by the government, usually relative to the British pound. When the price of a currency is fixed, changes in its real value may be masked. Prices send signals to buyers and sellers about the relative value of goods and services, and when currency is fixed signals of changing values can be obscured.

In 1984 the government decided to allow the dollar to float, which meant its price in other currencies was determined by market demand. The intention was to align the price of currency with most other items that were bought and sold commercially, be it hotel rooms, concert tickets, cars, or fruit and vegetables. The risk of an unregulated market for a currency is that it can become the object of speculation – people buy when the value is low and hope to sell when it is high, transactions which are independent of the currency’s value in the real economy.

In the early 2000s the New Zealand dollar was readily exchanged with a large number of other currencies, but the most commonly traded ones were the Australian dollar, the American dollar, the European euro, the Japanese yen and the British pound – all currencies of New Zealand’s major trading partners.

In general the rate of exchange with these currencies moved up or down in parallel, but the exchange rates with the Japanese yen and the American dollar were more volatile.

Trade weighted exchange rate index

To find the international price of New Zealand currency economists weight the various exchange rates by their share of New Zealand international trade. This is known as the trade weighted exchange rate index (TWI).

Between 1974 and the early 1990s the TWI declined steadily. The main cause was the higher rate of price inflation in New Zealand compared to its major trading partners – changes in the exchange rate neutralised the effects of differences in relative inflation rates, more or less maintaining the international competitiveness of New Zealand goods, but meaning New Zealanders had to pay high prices in New Zealand currency for overseas goods or for foreign travel.

After 1993 the exchange rate for the New Zealand dollar strengthened, and prices for imported goods such as cars and clothing lowered. This meant lower domestic price inflation. The exchange rate is one of the main mechanisms by which governments can control inflation.

How to cite this page:

Adolf Stroombergen, 'Prices and inflation - Terms of trade and the exchange rate', Te Ara - the Encyclopedia of New Zealand, http://www.TeAra.govt.nz/en/prices-and-inflation/page-6 (accessed 16 October 2019)

Story by Adolf Stroombergen, published 11 Mar 2010