4.1.4 Terms of trade

What is the terms of trade?

The terms of trade is the ratio of X prices to M prices

What is the calculation of terms of trade?

Calculation of terms of trade=

Index of X prices/ Index of M prices

What does a rise in the terms of trade index indicate?

Rise in terms of trade index indicates that a country can buy more M for each unit of X→ improvement in terms of trade // X prices rise or M prices fall

What does a fall in the terms of trade index indicate?

Fall in the terms of trade index indicates that a country can buy fewer M for each unit of X→ deterioration in terms of trade// X prices fall or M prices rise

What does an index figure above 100/ less than 100 tell you about the terms of trade?

• Figure above 100 shows→ improvement in terms of trade.

• Figure less than 100 → worsening in terms of trade

use 100 as a base figure

What are the factors influencing a country’s terms of trade?

The factors influencing a country’s terms of trade=

• inflation rates

• exchange rates

• price elasticity

• relative productivity growth

• global commodity prices

• changes in D

• changes in Y

In general, anything that affects the price of a country’s M or X will affect terms of trade

Why do inflation rates influence a country’s terms of trade?

Inflation rates influence a country’s terms of trade=

• inflation rates- inflation leads to higher prices. If UK inflation is higher than trading partners e.g US inflation, then relatively, export prices will increase by more than import prices. This will lead to a fall in exports, as it is too expensive to buy from the UK

Why do exchange rates influence a country’s terms of trade?

Exchange rates influence a country’s terms of trade=

• (SPICED) if £ appreciates, X more expensive→ fall in X, as it is too expensive to buy from the UK→ improve terms of trade

Why does price elasticity influence a country’s terms of trade?

Price elasticity influences a country’s terms of trade=

• if a product is price inelastic then firms can increase the price of exports, so X revenue may increase as higher prices outweigh relatively small fall in Qty D.

• if price elastic, Qty D > price so X revenue falls.

• (The impact on the terms of trade will depend upon the Marshall-Lerner condition (see 4.1.8)

Why does relative productivity growth influence a country’s terms of trade?

Relative productivity growth influences a country’s terms of trade=

• faster productivity growth can lower X costs and prices→ may worse terms of trade, as X prices fall relative to M prices. This can be caused by new technology, more efficient labour

Why do global commodity prices influence a country’s terms of trade?

Global commodity prices influence a country’s terms of trade=

• a boom in commodity prices can sharply improve the terms of trade for primary-product exporters.

Why do changes in demand influence a country’s terms of trade?

Changes in demand influence a country’s terms of trade=

stonger global demand for a country’s X may raise X prices→ improve the terms of trade

Why do changes in income influence a country’s terms of trade?

Changes in income influence a country’s terms of trade=

this affects the pattern of D for g and s. For e.g a rise in world Y causes a rise in D for tourism and so a country with a sstrong tourist industry, e.g Spain, may see a rise in prices in that industry and hence an increase in their terms of trade. The perbish- singer hypothesis suggest the LR price of primary goods declines in proportion to manufactured goods, which means those dependent on primary X will see a fall in their ToT.

What is the impact of changes to a country’s ToT?

Impact of a country’s ToT=

• X will fall as X prices increase→

• improvement in ToT, but worsening current account deficit as M>X→

• Deterioration of in balance of trade→ depreciation, as less D for UK X sees a lower sterling price→

• M prices increase→ ToT worsen→

• inflationary pressure→

• X will become more attractive and process begins again

The effects depend heavily on PED for X and M

What is the potential benefit and cost to improvement in ToT?

Improvement in ToT- when X prices rise or M prices fall.

• potential benefit- each unit of X buys more M, which may improve living standards

• potential cost- if X D is elastic, rise in X prices may cause a large fall in X volume, reducing X revenue→ worsening current account and GDP

What is the potential benefit and cost to deterioration in ToT?

Deterioration in ToT- when X prices fall or M prices rise.

• potential benefit- if X D is elastic, lower X prices→ may cause a large rise in X sales→ increasing X revenue, GDP, and employment

• potential cost- more X are needed to buy the same volume of M→ may reduce living standards