Terms of Trade

Lesson 1 - Higher Level

Learning outcomes:

Explain the meaning of terms of trade

Distinguish between and improvement and deterioration in the terms of trade
Explain how the terms of trade are measured
Calculate the terms of trade
Explain that the terms of trade may change in the short term due to changes
in demand conditions for exports and imports, changes in global supply of key
inputs (such as oil), changes in relative inflation rates and changes in relative
exchange rates.
Explain that the terms of trade may change in the long term due to changes in
world income levels, changes in productivity within the country and
technological developments.

Terms of Trade

Concept that relates the prices that a country receives for its exports to the
prices it pays for its imports
Price of exports relative to imports
Amount of imports that can be bought per unit of export
An increase in the price of exports, import price constant, means
more imports can be bought with the same quantity of export.
Increase in the price of imports, export price constant, means less
imports can be bought with the same quantity of exports
Both export and imports are measured in terms of the domestic currency

Improvement vs. Deterioration

Improvement in Terms of Trade
Country receives more imports with the same amount of exports
Can arise from either:
Increase in cost of exports
Fall in the price of imports
Deterioration in Terms of Trade
Country receives fewer imports for the same amount of exports
Can arise from either:
Decrease in price of exports
Increase in price of imports

Calculating Terms of Trade

Measure using a weighted price index with base year

Both price indexes (import & exports) must be calculated using same base
year
Terms of Trade = Index of Export prices divided by price index for imports xs
100
Value of Terms of Trade in the base year is always 100
If Terms of Trade is < 100
Deterioration in Terms of Trade
Avg. export prices have decreased relative to import prices
Avg. import prices have increased relative to export prices
If Terms of Trade > 100
Improvement in Terms of Trade
Avg. export prices have increased relative to import prices
Avg. import prices have decreased relative to export prices

Causes of Change in Terms of Trade - Short-run

Changes in Global Demand

Increase in Global Demand - price increases
Improvement in Terms of Trade for exporters
Exports now buy more imports
Deterioration in Terms of Trade for importers
Exports now buy less imports
Decrease in Global Demand - price decreases
Deterioration in Terms of Trade for exporters
Exports now buy less imports
Improvement in Terms of Trade for importers
Exports now buy more imports

Causes of Change in Terms of Trade - Short-run

Changes in Global Supply

Increase in Global Supply - price decreases
Deterioration in Terms of Trade for exporters
Exports now buy less imports
Improvement in Terms of Trade for importers
Exports now buy more imports
Decrease in Global Supply - prices increase
Improvement in Terms of Trade for exporters
Exports now buy more imports
Deterioration in Terms of Trade for importers
Exports now buy less imports

Change in Domestic Rate of Inflation

Price changes in one country relative to another have short-run effect on the Terms of
Trade

Higher rate of domestic inflation in Country A in relation to Country B

Country A export prices increase relative to import prices of Country B
Improvement in Terms of Trade for exporting country
Exporting same amount results in Country A being able to buy more imports
from Country B for the same amount of exports
Deterioration in Terms of Trade for importing Country B
Country B exports buy less imports due to the increase in price of country A
Vice versa if Country B inflation rate increase more than Country A

Changes in Exchange Rates

Remember Terms of Trade measures imports and export in the domestic
currency!

Depreciation/devaluation of the domestic currency

Price of imports increase in terms of the domestic currency
Export prices remain unchanged in relation to the domestic currency
Deterioration in Terms of Trade
Exports domestically purchase fewer imports
Appreciation of the domestic currency
Price of imports decrease in terms of the domestic currency
Export prices remain unchanged in relation to the domestic currency
Improvement in Terms of Trade
Imports are now cheaper in relation to exports

Long Term Cause of Change in Terms of Trade

Growths in Income affect Global Demand

As incomes increase Global Demand increases
Depends on Income Elasticity of Demand (YED)
YED < 1 for food (primary products) showing demand being less
responsiveness to changes in income.
YED > 1 for manufactured goods showing demand being more
responsive to changes in income.
As income rise, prices for food & primary goods rise less rapidly
than manufactured goods.
Countries who export manufactured goods or import primary product
experience improvement in the Terms of Trade.
Countries who import manufactured goods or export primary products
experience deterioration in the Terms of Trade.

Long Term Cause of Change in Terms of Trade

Changes in Productivity
Productivity (output per unit of hours worked) tend to increase over
long period of times thus influencing domestic supply.
Increase in technology, more highly educated and/or improved
management
Lower cost - increasing supply - shifting supply right - lowering prices
If productivity increases for exporting countries - prices decrease leading to a deterioration in the Terms of Trade
Export prices fall relative to import prices
Each unit of export purchases less units of imports

This holds true for technological innovation

Long Term Cause of Change in Terms of Trade

Trade Protection
Small countries who restrict imports or expand exports cannot affect world prices thus
facing a perfectly elastic supply curve.
If a country has a large share of the import/export market, it may be able to affect the
world prices.
US automobile demand is high - could limit imports - decreasing demand - leading
to lower prices for exporting countries
Lead to an Improvement in the Terms of Trade
US exports now buy more imports
Large countries who provide subsidies can lead to an increase in supply - decrease in
prices
Example: US Agricultural subsidies - increase global supply - decreasing prices
Exporting countries of agricultural products (usually developing countries)
face falling prices.
Results in a deterioration in the Terms of Trade for the developing country