The terms of trade represent the price of a country's exports relative to its imports. In a small, open economy such as Canada’s, the producers of commodities for export are price takers in world markets, and consequently, these prices are an exogenous component of the terms of trade. Differential changes in the price of exports relative to imports are the primary driver of the terms of trade. The exchange rate is also a key determinant through its effect on the price of imports. In Canada, this relationship is especially important because the currency responds to changes in the price of key export commodities. The relationship has broadened over the last few years as the currency has become very responsive to changes in the world price of crude oil. The result is that commodity price shocks significantly influence Canada's terms of trade.

Recent Developments

The terms of trade have trended steadily higher over the last few years and peaked at very high levels in the middle of 2008. The runup over those years was unprecedented, and it was due partly to the steady upward move in the price of Canada's export commodities and an accompanying appreciation of the Canadian dollar. This upward trend represents an improvement in the terms of trade, and it means that (in export terms) Canadians paid considerably less for imports in 2008 than in prior years.

Most of the improvement in the terms of trade came from higher export prices. Over the five-year period from 2003 to 2008, the deflator for total exports increased 17%. The Canadian dollar appreciated sharply, from an annual average of 72.2 U.S. cents in 2003 to 96.4 cents in 2008, and that trend dampened import prices.

The price of a country's exports relative to its imports is important in the GDP deflator, particularly in an economy with a large trade sector, such as Canada. The improvement in the terms of trade caused the GDP deflator to increase 17% from 2003 to 2008, and nominal GDP increased 32% during that period.

The increase in the terms of trade also had a significant effect on real income over that period. The Bank of Canada estimated that it caused an 8.5% increase in real disposable income per capita, representing half of the total increase during that period.

How Do the Terms of Trade Affect the Economy?

The manner in which changes in the terms of trade influence the economy is somewhat complicated. Our econometric model can help us to understand the various effects and the channels. Commodity price shocks are generally put into two broad categories: changes in energy prices or changes in non-energy prices. We considered the impact of these two types of shocks.

The first shock is a 40% increase in the price of crude oil that is sustained for a number of years. The shock causes the Canadian dollar to appreciate and the terms of trade to improve. The most notable effect on aggregate demand is via business investment in machinery and equipment. The linkage occurs through lower prices for foreign-produced capital goods, which encourage imports and provide a lift to business fixed investment in machinery and equipment. There is also an increase in personal disposable income and an increase in imports that is related to the exchange rate. The net impact on real GDP over the first few years of the shock is positive.

A 40% increase in non-energy, non-agricultural commodity prices causes an even larger appreciation of the Canadian dollar in our model. The improvement in the terms of trade is not quite as large in this scenario. There is a similar impact on fixed investment in machinery and equipment, but under this shock the increase in imports is larger (because of greater currency appreciation). The net impact on real GDP is slightly negative.

These simulation results are borne out in the data for the 2003–08 period. The key linkage was at work as the improvement in the terms of trade had the effect of providing an added lift to business fixed investment in machinery and equipment. In fact, its share of GDP increased 2 full percentage points over that period, and this was primarily due to the decline in the deflator for machinery and equipment imports.

Implications for the Outlook

The global recession that began last year sparked a sharp selloff in commodity markets that was accompanied by a sizeable downshift in the terms of trade. In the first quarter of this year, the terms of trade fell back to the level that existed in the second quarter of 2004. Nonetheless, it remains high relative to historic standards, partly because of persistently high crude oil prices and the strength of the Canadian dollar. As long as the terms of trade remain at elevated levels, they will provide an important support for the Canadian economy over the coming quarters.