Factors Affecting Terms of Trade

Overview of Terms of Trade

  • Terms of trade are influenced by movements in export and import prices.
  • Factors affecting terms of trade:
    • Microeconomic factors
    • Macroeconomic factors

Factors Affecting the Price of Exports

Microeconomic Supply Factors

  • Changes in Technology: If technology increases output, export prices may fall.
  • Supply Shock: Natural disasters or other unexpected events can affect export supply, impacting prices.
  • Overseas Cartels: Agreements like OPEC cutting supply can raise production costs and increase export prices where involved.

Microeconomic Demand Factors

  • Change in Tastes and Fashion: Shifts in consumer preferences can affect demand for exports.
  • World Population Growth: Increased global population can heighten demand for commodities, driving export prices up.
  • Protectionism: If trading partners engage in protectionist measures, demand for exports may decrease, lowering prices.

Macroeconomic Supply Factors

  • Level of Productivity: Higher productivity can increase supply and decrease export prices.
  • International Competitiveness: A country's competitive position can affect its export prices.
  • Tax Policies: Tax reforms (e.g., reduction in small business tax) can lower costs, boost supply, and lower export prices.
  • Wages: Higher wages can increase production costs, decreasing supply and raising export prices.

Macroeconomic Demand Factors

  • World Economic Growth: As global economies grow, demand for exports can increase, raising prices.
  • Incomes of Trading Partners: If incomes in partner countries rise, demand for exports can increase, leading to higher prices.

Factors Affecting the Price of Imports

Microeconomic Supply Factors

  • Protectionism Policies: Higher tariffs can increase import prices.
  • Overseas Cartels: Similar to exports, changes in overseas agreements can affect import prices.
  • Transportation Costs: Increases in transportation costs can raise import prices.
  • Supply Shock: Unexpected events affecting supply can raise prices.

Microeconomic Demand Factors

  • Change in Tastes and Fashion: Consumer preferences can influence demand for imports.
  • Population Growth: Higher population can lead to increased demand for imports.

Macroeconomic Supply Factors

  • Level of Productivity: Affects the ability to supply imports and their prices.
  • International Competitiveness: Competition affects import prices.
  • Tax Policies: Increased income tax can reduce disposable income, decreasing expenditure on imports.

Macroeconomic Demand Factors

  • Domestic Economic Growth: Improved economic conditions can enhance demand for imports as businesses and households spend more on foreign goods.
  • Change in Domestic Income: Rising household incomes lead to greater demand for imports.

Exchange Rate Effects on Terms of Trade

Exchange Rate Appreciation

  • Impact: An appreciation of the currency increases purchasing power for imports, leading to a favorable terms of trade.
  • Example: An increase in the dollar from $0.5 USD to $1 USD decreases the cost of a US toy car from $20 AUD to $10 AUD, lowering import prices while keeping export prices constant.

Exchange Rate Depreciation

  • Impact: A depreciation of the currency reduces purchasing power for imports, leading to unfavorable terms of trade.
  • Effect on Export Price Index: Remains unaffected as exports are measured in local currency, while import prices rise due to decreased currency value.