Terms of trade

The Terms of Trade

• Terms of trade refer to the ratio of a country’s average price of exports to the country’s average price of imports

• The relative price of imports and exports can have a direct bearing on the standard of living within a country

  • Exporting goods which are highly priced results in higher incomes and the ability to buy cheaper imports

  • The terms of trade capture the relationship between the average prices of a country's exports and imports

Calculation of the terms of trade

• The index for exports and imports is created in much the same way that a consumer price index is created (using a weighted basket of imports and exports)

Factors influencing a country's terms of trade

1. Relative inflation rates: Inflation increases the price of goods/services within a country. This means that their price is now more expensive to the rest of the world. If the exports are price inelastic in demand this will improve the terms of trade, if elastic then it is likely to worsen the terms of trade

2. Relative productivity rates: continuous improvements in productivity can lower costs and these can be passed on in the form of lower prices. Lower prices for export products will mean that the terms of trade will deteriorate i.e. fewer imports can be bought with one unit of exports

3. Changes in exchange rates: exchange rates constantly change the price of exports and imports. If prices change then the terms of trade between the two countries change. Specific data would need to be provided in order to determine if the terms of trade have improved or deteriorated for each trading partner.

Impact of Changes in the Terms of Trade

These include

• Changes to the current account balance in the Balance of Payments

• Changes to national output (GDP)

• Changes to unemployment levels

• Changes to the level of international competitiveness

• Changes to disposable income

• Changes to standards of living

The impact of changes to the terms of trade are more complex than assuming that an improvement in the terms of trade is good and a deterioration is bad

• E.g. Improvement in terms of trade → one unit exports buys more imports → standard of living improves

  • However, it depends on what caused the improvement and on the price elasticity of demand for exports and imports

  • If the improvement was caused by an increase in the price of exports, then following the law of demand fewer exports will be consumed by foreigners. How much fewer depends on the PED for exports. This could worsen the standard of living

PED and Changes To the Terms of Trade

Condition (ToT)	Cause	PED Value	Likely outcome
Improvement	Price of exports rises	If PED of exports is inelastic then the reduction in quantity demanded will be less than the increase in price and the economy will benefit	Output increases Unemployment decreases Standard of living improves
Improvement	Price of imports falls	If PED of imports is elastic (necessity) then the increase in quantity demanded will be more than the decrease in price and the economy will spend more on imports	More disposable income Standard of living improves Domestic output may fall as foreign consumption increases
Deterioration	Price of exports falls	If PED of exports is elastic then the increase in quantity demanded will be more than the decrease in price and the economy will benefit	Output increases Unemployment decreases Standard of living improves
Deterioration	Price of imports rises	Where demand for imports is price inelastic, consumers would demand the goods in similar proportions and thus spend significantly more on imports	Domestic output unlikely to fall Imports will decrease slightly Less disposable income so worse standard of living