International Trade Part 2: Terms of Trade and Exchange Rates

Definition: Terms of trade refers to the specific rate at which the products of one country are exchanged for the products of another.
Measurement via Index: A country’s terms of trade is typically expressed as an index that compares export prices against import prices.
Calculation Formula: $\text{Terms of Trade Index} = \frac{\text{Unit Price of Export}}{\text{Unit Price of Import}} \times 100$
Index Base and Interpretation: - The index begins at a base level of $100$ . - Favourable Terms: Any increase in the index value above $100$ is presumed to be favourable. - Unfavourable Terms: Any decline in the index value below $100$ is considered unfavourable. - Any fluctuation in the price of exports or the price of imports directly affects the terms of trade, shifting the status between favourable and unfavourable.

Relative Price Changes: - A reduction in the price of a country's exports relative to the price of its imports. - A reduction in the price of imports while the price of exports remains unchanged. - An increase in the price of exports while the price of imports remains unchanged.
Economic Drivers: - The elasticity of demand for both exports and imports. - Increases or decreases in the level of domestic economic growth. - Increases or decreases in international income levels.

General Regional Trend: Most Caribbean countries typically experience unfavourable terms of trade due to the nature of their products and the elasticity of demand for those products.
Trade Logic and Specialization: - To benefit from specialization and trade, a country will settle for a trade price only if its "sacrifice" (the cost of obtaining goods through trade) is lower than the cost of producing that same amount of goods locally. - If the sacrifice required for trade is higher than the local production cost, the country will choose to produce the goods locally.
Dependency on Primary Products: Caribbean economies are heavily dependent on the export of commodities or primary products, specifically: - Rice - Sugar - Bananas - Bauxite
Macroeconomic Consequences: When the prices of these primary products fall on the global market, the Gross Domestic Product (GDP) of these economies declines, which negatively impacts their overall economic growth and development.

Definition: An exchange rate is the amount of one currency that must be sacrificed or exchanged in order to acquire another currency.
Necessity for International Trade: Exchange rates are vital because suppliers often refuse to accept foreign currency. Suppliers require payment in their own domestic currency to: - Pay workers' wages. - Purchase raw materials. - Realize and pay out profits.
Marketplace: The physical or digital exchange of foreign currencies occurs within a foreign exchange market.

Key Functions: 1. Facilitating the transfer of purchasing power between different countries through their respective currencies. 2. Providing credit for international trade transactions. 3. Facilitating the purchase of foreign exchange in the forward market. 4. Hedging against various foreign exchange risks.
Types of FX Markets: - Spot Market: A market where foreign currency is bought or sold for exchange immediately (in the present time). - Forward Market: A market where a contract is established in the present, at a rate agreed upon now, to buy or sell a specific quantity of currency at a confirmed future date.

Revaluation: This refers to an increase in the official value of a currency. This term is specific to a fixed exchange rate regime.
Appreciation: This occurs when a change in the exchange rate allows a unit of a country's currency to buy more units of a foreign currency. This is associated with managed or floating exchange rate regimes.
Devaluation: This refers to a deliberate reduction in the official value of a currency within a fixed exchange rate regime.
Depreciation: This occurs when a change in the exchange rate results in a unit of a country's currency buying fewer units of a foreign currency. This is associated with managed or floating exchange rate regimes.

Price Fluctuations: Changes in domestic prices of goods and services while foreign prices remain relatively constant.
Relative Income: Changes in the relative income of people in foreign nations.
Interest Rates: Changes in relative interest rates which determine the attractiveness of investing domestically versus internationally.
Market Preferences: Changes in international tastes and preferences for specific goods or services.
Speculation: The belief held by speculators that the rate of exchange is likely to change in the future.

Flexible or Fluctuating Exchange Rate Regime: - Mechanism: This system is governed entirely by the demand and supply flows within foreign exchange markets. - Movement: The exchange rate is permitted to vary upward or downward based on market demand and supply for that currency.
Fixed Exchange Rate Regime: - Mechanism: The rate is fixed by law. - Government Role: The government secures the rate by enforcing laws when the fixed rate is threatened. - Intervention: If there is excess supply, the government buys its own currency to prevent depreciation. If there is excess demand, the government sells its currency to prevent appreciation. - Examples: Barbados, Guyana.
Managed Float or "Dirty Float" Regime: - Mechanism: The government allows market forces to set the rate but intervenes to prevent sudden or volatile changes. - The Band: The government implements a "band" that allows for some freedom of movement. If the currency moves above or below the limits of this band, the government intervenes to defend the currency. - Examples: Jamaica, Haiti, Dominican Republic.

Fixed Regime: - Central Bank Intervention: Yes. - Determination: Set by the Central Bank. - Effect: The rate remains fixed.
Floating Regime: - Central Bank Intervention: No. - Determination: Market forces (Demand and Supply). - Effect: The rate is subject to changes.
Managed/Dirty Float Regime: - Central Bank Intervention: Sometimes (limited intervention). - Determination: A band is set; market forces apply, but the Central Bank intervenes if the rate moves outside the band. - Effect: The rate is subject to changes within a set limit.