How does a terms-of-trade shock affect a country's currency?

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AcadiFi · Accepted Answer

Terms of trade (TOT) is the ratio of export prices to import prices. A favorable TOT shock (export prices rise relative to imports) increases national income, improves the trade balance, and generally appreciates the real exchange rate. The mechanism: higher export revenues boost domestic wages and spending, driving up non-tradable prices and appreciating the RER.

Classic examples: Australia's AUD/USD correlates 0.75 with iron ore prices; Norway's NOK moves with Brent crude; Canada's CAD tracks oil and lumber. When iron ore rallied from $45 to $220 (2020-2021), AUD/USD rose from 0.58 to 0.78. Torresley Commodity Macro models the AUD as 0.003 * iron_ore_spot + base, producing directional FX calls that average 60% hit rate.

Theoretical derivation: TOT appreciation raises national income Y, which lifts demand for non-tradables (assuming income elasticity exceeds 1), pushing up their relative price, the Balassa-Samuelson logic in reverse. For import-dependent countries, the opposite holds - rising oil prices weaken the TOT and depreciate the currency (Japan, South Korea, Turkey).

Policy implications: commodity-exporting central banks often target a smoothed TOT-adjusted exchange rate to avoid Dutch disease dynamics (see related question). Investors can use TOT as a forward-looking currency signal, though short-run exchange rates also respond to monetary policy, capital flows, and risk sentiment.

How does a terms-of-trade shock affect a country's currency?

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