4.1.4 Terms of Trade

what is the terms of trade

Ratio of a countries export price index and import price index - quantity of imports a country can obtain with a given volume of exports.

Terms Of Trade calculation

(Index of export prices / index of import prices) x 100

What affects the Terms of Trade

• Changes in exchange rates

• relative inflation

• productivity

• Labour costs

• Import & Export prices

How does inflation impact the TOT

If a country experiences higher inflation than its trading partners, its export prices might rise faster than import prices, leading to a deterioration in the TOT.

if inflation is lower domestically, the TOT may improve, as export prices remain relatively stable while import prices rise, leading to an improvement in the TOT

How does productivity impact the TOT

When a country increases productivity, it can lower production costs, potentially improving the TOT if export prices are maintained or if higher quality boosts export demand.

If productivity decreases, the cost of production rises, which may require higher prices to maintain profitability, potentially worsening the TOT as the cost of imports may rise relative to exports.

How does labour costs impact the TOT

If labor costs rise without a corresponding increase in productivity, production becomes more expensive, potentially leading to higher export prices. This can worsen the TOT if other countries are able to produce similar goods more cheaply.

If labor costs decrease or grow slower than those in trading partners, the country can produce goods more cheaply, possibly improving the TOT by either lowering export prices or increasing profit margins while maintaining prices.

What are the impacts of improving TOT

• Increased standard of living due to cheaper imports (but bad for domestic industry)

• Decreased imported inflation due to decreased prices for imports (decreased cost push inflation

• If exports are PED inelastic, then prices of exports would increase so increased value of exports so increase in AD so economic growth