Terms of trade 4.1.4

What is terms of trade?

The ratio of export prices to import prices

What is the index of export prices?

The average price of commonly exported goods. e.g for the UK, this is financial services

What is the index of import prices?

The average price of commonly imported goods, e.g in the UK, we mostly import cars and gold

What is the formula for terms of trade?

Index of export prices/ index of import prices x100

When do we say terms of trade have improved?

If the price of exports increase or the price of imports decrease

When do terms of trade deteriorate?

If price of exports decrease or if the price of imports increas

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

Raw materials

Tariffs

Exchange rates

Inflation rates

How do raw material prices influence terms of trade?

If the cost of raw materials decrease…

developed countries import these raw materials, and it will now be cheaper to do so which leads to an improvement in terms of trade. e.g. USA imports over 9 million barrels of oil per day

developing nations usually export raw materials, lower prices mean lower prices of exports so a deterioration in terms of trade.

How do changes in tariffs influence terms of trade?

Increasing tariffs lead to an increase in import prices lead to an increase in import index lead to deterioration of terms of trade. Removing tariffs improves terms of trade e.g argentina removing 35% laptop tariff

How are inflation rates influencing terms of trade?

An increase in inflation rate will lead to an increase in export price index, but its effect on terms of trade depends on inflation rates from other countries and the inflation rate of trading partners.

What is impacted by changes in terms of trade?

Living standards

Competitiveness

How are living standards impacted by terms of trade

An improvement in the terms if trade means countries can afford to buy more foreign imports, which means consumers can afford more imports, thus living standards will increase

e.g. in 2017 the UK had an inflation rate of 2.7 compared to Switzerland with only 0.8, which meant the UK could afford to import more watches and chocolate from Switzerland.

(it is the opposite for deterioration)

How is competitiveness impacted by terms of trade?

When the £ becomes weaker, import prices increase and export prices decrease. This is a deterioration in terms of trade. However, this will increase competitiveness as lower export prices will attract foreign consumers to buy our exports as they may be cheaper than foreign competitors.

If more foreign consumers are importing our goods, domestic exports are increasing.

This has 3 knock on effects in the UK.

An increase in exports leads to an increase in AD, which increases Real GDP.

An increase in exports leads to an increase in AD, which increases the derived demand for labour which increases employment

An increase in exports, leads to an increase in export revenue, which reduced the UK’s current account deficit.

This process is the opposite when the pound becomes stronger ( we are less competitive)