4.1.4 Terms of trade

Terms of trade

Rate of exchange of one product for another when two countries trade

Improvement in the terms of trade

Said to be favourable if the terms of trade increase as the country can buy more imports with the same level of exports

Calculation

avg export price index / avg import price index X 100

Improvement would be caused by:

Rise in export prices or fall in import prices

Short run influences

Exchange rate, inflation and changes in demand/supply

Long run influences

Improvement in productivity relative to a country’s main trading partners will decrease terms of trade since export prices fall in comparison to import prices

Changing incomes as rising world incomes will cause a rise in demand for tourism in a certain country which would rise their prices, increasing their terms of trade

Prebisch-singer hypothesis

Long run price of primary goods decline in proportion to manufactured goods which means those dependent on primary exports will see a fall in their terms of trade

Disadvantages

If PED of exports/imports is elastic, it may worsen the current account on the balance of payments

An improvement is likely to lead to a fall in GDP and a rise in unemployment as exports rising in price will mean there is less and imports costing less will rise. Causing reduction in production in the country.

Advantages

An improvement due to an increased demand for exports would be beneficial for the country.

A deterioration by an improvement in international competitiveness would also be beneficial.