4.1.4 Terms of trade

What do terms if trade measure?

• The terms of trade measures the rate of exchange of one product for another when two countries trade. It tells us the quantity of exports that need to be sold in order to purchase a given level of imports.

• Movement in the terms of trades is said to be favourable if the terms of trade increase as the country can buy more imports with the same level of exports. This is called an improvement in the terms of trade. It is unfavourable if they decrease, when export prices fall or import prices rise. This is called a deterioration .

Calculation of terms of trade

• It is measured in the form of an index because it is calculated from the weighted average of thousands of different export and import prices e.g. changes in the price of oil have larger impacts on the terms of trade than changes in the price of a Rolls Royce.

• (average export price index/average import price index) x100

Factors influencing a country’s terms of trade

• An improvement in the terms of trade will be caused by a rise in export prices or a fall

  in import prices. A deterioration will be caused by a fall in export prices or a rise in import prices.

• In the short run, exchange rates, inflation and changes in demand/supply of

  imports or exports affect the terms of trade since these affect the relative prices of

  imports and exports.

• In the long run, an improvement in productivity compared to a country’s main trading partners will decrease the terms of trade since export prices will fall relative to import prices. This can be caused by new technology, more efficient labour etc.

• Another long run factor is changing incomes. This affects the pattern of demand for goods and services. For example, a rise in world income causes a rise in demand for tourism and so a country with a strong tourist industry, such as Spain, may see a rise in prices in that industry and hence an increase in their terms of trade. The Prebisch-Singer hypothesis suggests the long run price of primary goods declines in proportion to manufactured goods, which means those dependent on primary exportswill see a fall in their terms of trade.

• In general, anything which affects the price of a country’s imports or exports will affect its terms of trade.

Impacts of changes

• If PED of exports and imports is inelastic, a favourable movement in terms of trade

  would improve the current account on the balance of payments whilst if it is elastic,

  a favourable movement would worsen the current account.

• An improvement in the terms of trade is likely to lead to a fall in GDP and a rise in unemployment, since if it is caused by a rise in export prices, exports will fall and if it is caused by a fall in import prices, imports will rise. Both of these causes a reduction in production within the country and so a fall in jobs and output. However, a long term decline in the terms of trade suggests a long term decline in living standards as less imports can be bought.

• It is important to look at the cause of the change. If an improvement has occured due to increased demand for exports, then this will be beneficial for the country. If a deterioration is caused by an improvement in international competitiveness, this will also be beneficial. The export and import revenues are more important than the price alone. For an improvement to be beneficial, export revenues must increase.