production faster … than at any earlier date. … one outstanding economic problem seems to remain, and it has been frequently discussed academically and in public debate : can the boom be sustained without a dangerous degree of inflation? ” ( bowen 1960 ). “ the economic situation ”, address to ceda annual dinner, melbourne, 19 november 2008. available at : http : / / www. rba. gov. au / publications / bulletin / 2008 / dec / pdf / bu - 1208 - 3. pdf. this is a very long - run chart of australia ’ s terms of trade. you may have noticed the reserve bank saying a lot about the terms of trade in the past few years. before i describe the chart, why is it important? our terms of trade have a big bearing on national income. in economic commentary, there is typically a very strong focus on gdp – the value of production – as a summary of national material progress. there is also quite rightly an emphasis on lifting productivity – real gdp per hour worked – as the source of our growth of material living standards. for open economies, though, our standard of living is affected not just by the physical output we can obtain from our resources of labour and capital, but also by the purchasing power of that output over things we want to have from the rest of the world. this is what the terms of trade is measuring. it is the relative price of our export basket in terms of imports. at the extreme, if the economy were open to the extent that we exported all our production and imported all our consumption, then the price of exports relative to imports would determine our living standards entirely, for any given level of productivity per hour worked. as it is, australia is not that open, and not as open as many smaller economies, but it is considerably more open than the really large economies like the united states, the euro area or japan. so the terms of trade matter. when the terms of trade are high, the international purchasing power of our exports is high. to put it in very ( over - ) simplified terms, five years ago, a ship load of iron ore was worth about the same as about 2, 200 flat screen television sets. today it is worth about 22, 000 flatscreen tv sets – partly due to tv prices falling but more due to the price of iron ore rising by a factor of six. this is of course a trivialised example – we do not want to use the proceeds of exports

we use the additional income, and how soon, and to questions of structural adjustment. one difficulty is that it matters a great deal whether the rise in the terms of trade is likely to be permanent or only temporary. unfortunately, we cannot really answer that question. it is obvious from my chart that past episodes tended not to be permanent, but they sometimes lasted several years and certainly long enough to be very disruptive. if the rise in income is only temporary, it would be desirable not to raise national consumption by very much. instead, it would make sense to allow the income gain to flow into a higher stock of saving, which would then be available to fund future consumption ( including through periods of temporarily weak terms of trade, which undoubtedly will occur in the future ). moreover, it would probably not make sense for there to be a big increase in investment in resource extraction if that investment could be profitable only at temporarily very high prices ( and which could come at the cost of reduced investment in other areas ). if the change is likely to be persistent, then income is likely to be seen as permanently higher. households and most likely governments will probably see their way clear to lift their consumption permanently, both of traded and non - traded goods and services. structural economic adjustment will also occur as the sectors whose output prices have risen, now being more profitable, will seek to expand, in the process attracting productive resources – labour and capital – away from other sectors whose output will decline as a share of gdp. australia ’ s floating exchange rate, which tends to rise in line with the increase in the terms of trade, helps the reallocation of labour and capital by giving price signals to the production sector. the higher exchange rate also speeds the spread of the income gains from the terms of trade rise to sectors other than the resources sector, by directly increasing their purchasing power over imports. the resulting rise in imports spills demand for tradable goods and services abroad, which helps to reduce domestic inflation. so the shift in the terms of trade will, unless clearly quite temporary, drive shifts in the structure of the economy. it is easy, of course, to speak in the abstract of “ reallocation of productive resources ”, but this means that some businesses and incomes become relatively smaller ; jobs growth in some areas slows even as in others it picks up. some regions struggle more than others. some sources of government revenue are adversely affected even as other sources see an improvement. this process will be