Terms of Trade

Lesson 2 - HL

Learning outcomes:

Explain how changes in the Terms of Trade in the long term may result in a
redistribution of income.
Examine the effects of changes in the Terms of Trade on a countrys current
account, using the concept of PED for imports and exports.

Terms of Trade & Global Output & Income Redistribution

Long-term improvements in the Terms of Trade redistribute global output and

income to Country A experiencing the improvement.
Country A can purchase a larger quantity of imports with the same exports.
Country A exports are increasing in relation to import prices
Country A - Improving Terms of Trade has greater opportunity for growth
Import more capital inputs used for production
Increased standard of living - importing more consumer goods.
Country B - Deteriorating Terms of Trade
Fewer opportunities to acquire needed capital goods
Lower growth & Standard of Living - many developed countries face this
problem.

Terms of Trade - Current Account Relationship

Changes in the Terms of Trade directly influences the Current Account

Balance of Trade
Export Revenues minus Import Expenditures
An improvement in the Terms of Trade does not always improve the Balance of
Payments
Causes of Changes in the Terms of Trade
Due to a change in Demand
Terms of Trade & Balance of Payments change in the same
direction
Due to Change in Supply
Terms of Trade & Balance of Payments change dependent on PED

Changes in Demand

Change in Demand influences the Terms of Trade & Current Account move in the
same directions.
Increase Demand - Improved Terms of Trade - Current Account moves to surplus

Country A is an exporter of Cotton

Increase in Demand
Quantity of Cotton traded increases Country A
Price of the Cotton increases globally
Higher Global Price - Improvement in the Terms of Trade
Since Price and Quantity increased - Revenues increased (P X Q) - Current Account moves
towards Surplus
Country A is an exporter of Cotton
Decrease in Demand
Quantity of Cotton traded decreases
Price of Cotton decreases globally
Deterioration in the Terms of Trade
Lower quantity of exports (Q) - Decrease in Price (P) - Export Revenues decrease
Current Account moves toward deficit

Changes in Supply

Domestic production exported goods decreases

Decrease Supply - Increase in price of exports Improvement in Terms of Trade

Current Account - Total Export Revenue

Depends on PED
PED > 1 - Elastic
Decrease Supply - Increase in Price
-Decrease in Total Revenue
Loss in Total Export Revenue
Current Account moves towards deficit
PED < 1 - Inelastic
Decrease Supply - Increase Price - Increase
in Total Revenue
Increase in Total Export Revenue
Current Account moves toward surplus

http://thismatter.com/economics/imag
es/elastic-inelastic-time-diagrams.png

Domestic Inflation

High domestic inflation, relative to a trading partner,

encourage an improvement in the Terms of Trade.
Whether an improvement in Terms of Trade leads to an
improvement in the Trade Balance depends on Price
Elasticity of Demand

Improvement in Terms of Trade caused by inflation improve the

Current Account (Trade Balance) when demand is inelastic.
Increase in Price leads to increase in Total Revenue
Price rises do not discourage export consumptions - export
revenue increase
Improvement in Terms of Trade caused by inflation reduce the
Current Account (Trade Balance) when demand is elastic.
Increase in Price leads to a decrease in Total Revenue
Price rises discourage export consumption - export revenue
decrease

https://upload.wikimedia.org/wikipedia/commons/t
humb/1/1c/Price_elasticity_of_demand_and_reve
nue.svg/220px-Price_elasticity_of_demand_and_
revenue.svg.png

Domestic Inflation
LDC Countries selling commodities (low PED) - increased domestic
inflation should be good news
Improve Terms of Trade and Trade Balance
However, LDC Countries cannot sell commodities at a higher price
worldwide
A lot of substitutes in the Global Market - leaves little room for LDC
countries to increase prices
LDC countries have good reason to keep Domestic Inflation under
control

Changes in Exchange Rate

Depreciation
Exports become less expensive
Imports more expensive
Deterioration in the Terms of Trade
Appreciation
Exports become more expensive
Imports less expensive
Improvement in Terms of Trade
Change in Trade Balance (Exports - Imports)
Depends on the Price Elasticity of Demand - consumers sensitivity to
changes in price.

Change in Exchange Rate

Depreciation
Exports cheaper - Deterioration in Terms of Trade
Trade Balance - PED
PED > 1 for Exports + Imports
Consumers are more sensitive to a change in price
Exports cheaper - % price decrease is less than % Quantity
increase
Exports Revenue increases
Improve Balance of Trade - moves towards surplus
PED < 1 for Exports + Imports
Consumers are less sensitive to changes in price
Exports cheaper - % price decrease is greater than % Quantity
increase
Export Revenues decrease
Worsening Balance of Trade - moves towards deficit

Change in Exchange Rate

Appreciation
Exports more expensive - Improvement in Terms of Trade
Trade Balance - PED
PED > 1 - consumers are more responsive to a change in price
Exports more expensive - % increase in price is less than the %
decrease in Quantity
Export Revenues decrease
Worsening Trade Balance - moves towards deficit
PED < 1 - consumers are less sensitive to change in price
Exports more expensive - % increase in price is greater than the %
decrease in Quantity
Export Revenues increase
Improvement in the Trade Balance - moves toward surplus

Changes in Exchange Rate

Depreciation

Appreciation

Deterioration
Terms of
Trade

Improvement
in Terms of
Trade

PED (X - M)
Elastic

Improvement
in Trade
Balance

PED (X - M)
Inelastic

Worsening of
Trade
Balance

PED (X - M)
Elastic

Worsening of
Trade
Balance

PED (X - M)
Inelastic

Improvement
in Trade
Balance